##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 
 Form 10-K
 (Mark One)
 þ
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 For the fiscal year ended December 31, 2005
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from                      to
 Commission File Number: 0-17995
 
 Zix Corporation
 (Exact Name of Registrant as Specified in its Charter)
 Texas(State or Other Jurisdiction of
Incorporation or Organization)
    
    75-2216818(I.R.S. Employer Identification Number)
 2711 N. Haskell Avenue, Suite 2200, LB 36, Dallas, Texas 75204-2960  (Address of Principal Executive Offices)
 (214) 370-2000  (Registrants Telephone Number, Including Area Code)
 Securities Registered Pursuant to Section 12(b) of the Act:
 None(Title of Class)
    
    Not Applicable(Name of Exchange on Which Registered)
 Securities Registered Pursuant to Section 12(g) of the Act:
 Common Stock
$0.01 Par Value  (Title of Class)
 o þ
 o þ
 þ o
 o
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##### 



Table of Contents
 PART I
    
    
    3Item 1.Business
    
    
    3Item 1A.Risk Factors
    
    
    12Item 1B.Unresolved Staff Comments
    
    
    20Item 2.Properties
    
    
    20Item 3.Legal Proceedings
    
    
    20Item 4.Submission of Matters to Vote of Security Holders
    
    
    20PART II
    
    
    21Item 5.Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
    
    
    21Item 6.Selected Financial Data
    
    
    22Item 7.Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    24Item 7A.Quantitative and Qualitative Disclosures About Market Risk
    
    
    45Item 8.Financial Statements and Supplementary Data
    
    
    46Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
    
    
    46Item 9A.Controls and Procedures
    
    
    46Item 9B.Other Information
    
    
    48PART III
    
    
    48Item 10.Directors and Executive Officers of the Registrant
    
    
    48Item 11.Executive Compensation
    
    
    48Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
    
    
    48Item 13.Certain Relationships and Related Transactions
    
    
    48Item 14.Principal Accounting Fees and Services
    
    
    48PART IV
    
    
    48Item 15.Exhibits, Financial Statement Schedule
    
    
    48Restated Articles of IncorporationAmendment and Confirmation of SubleaseDescription of 2006 Management Variable Compensation PlanSubsidiariesConsent of Deloitte & Touche, LLPConsent of Ernst & Young, LLPCertification of President and CEO Pursuant to Section 302Certification of Vice President, CFO and Treasurer Pursuant to Section 302Certification Pursuant to Section 906
  2




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PART I
 
 Item 1. Business
    eSecure
      
    
    ZixVPM® (Virtual Private Messenger)  an e-messaging gateway solution that provides
company-wide privacy protection for inbound and outbound email communications
    
    ZixVPM Alliance  an easy and economical way to enable direct, two-way secure
communication between partner companies
    
    ZixVPM Corporate  full-featured version of ZixVPM scaled to fewer users
 3




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
    
    ZixPort®  a secure Web-messaging portal
    
    ZixPort Corporate  full featured version of ZixPort scaled to smaller companies
    
    ZixMail®  a desktop solution for manually encrypting and securely delivering email
    
    ZixAuditor®  an assessment service used to analyze email traffic patterns and monitor
compliance with corporate and regulatory policies
 eHealth
     Recent Developments
 Sale of Businesses
 
    
    On March 11, 2005, the Company sold its Web Inspector® and Message Inspector® (MI/WI)
product lines to CyberGuard Corporation (CyberGuard) for $3,244,000 net of transactions
fees of $317,000. The Company realized a $1,035,000 gain on the sale.
    
    On September 30, 2005, the Company sold the remaining MyDocOnline, Inc. (MyDocOnline)
product (Dr. Chart®, an electronic laboratory orders and results product) to MITEM
Corporation (MITEM). As consideration, the Company received $150,000 in cash paid
immediately after closing, a promissory note with an original principal amount of $550,000
(subject to certain adjustments) payable by mid-August 2007, and a warrant exercisable for
400,000 shares of MITEM common stock. The Company realized a $4,751,000 loss on the sale.
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Private Placement of Common Stock and Warrants
 
    
    On August 9, 2005, the Company entered into a Securities Purchase Agreement (the
Purchase Agreement) with certain purchasers (collectively, the Purchasers) to issue and
sell an aggregate of 10,503,862 units consisting of (i) one share of common stock of the
Company, par value $0.01 per share (the Common Stock), and (ii) a related warrant to
purchase one-third of one share of Common Stock. Total proceeds from the private placement
were $26,288,000 before transaction costs of $2,087,000.
 Redemption of 2004 Convertible Notes
 
    
    In April 2005, the Company entered into amendments with the holders of the Companys
$20,000,000 convertible promissory notes to restructure the original purchase agreements
signed on November 2, 2004. The restructuring resulted in the Company recording an
additional discount of $2,518,000 relating to a beneficial conversion feature in the
amended notes. This amount was fully amortized into interest expense during 2005.
    
    The Company made all payments and redemptions required by the restructured convertible
promissory notes throughout 2005. The required 2005 payments and redemptions included
$10,000,000 of principal ($8,049,000 redeemed in stock, $1,951,000 paid in cash), $500,000
of early payment premium ($402,000 redeemed in stock, $98,000 paid in cash), and $1,204,000
of interest ($922,000 redeemed in stock, $282,000 paid in cash). The Company issued
5,274,133 shares of common stock during 2005 to pay the convertible promissory notes,
prepayment premiums and related interest.
    
    On December 30, 2005, the Company transacted an early extinguishment of 50% of the
remaining outstanding balance of the convertible promissory notes ($5,000,000) utilizing
restricted cash. As part of the partial debt extinguishment the Company paid a 5% early
payment premium and all accrued interest. The Company recorded a loss on the
extinguishment of debt of $1,283,000.
 Company History
   PC Magazines
    5




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Solutions and Services
 eSecure
  
    
    Privacy with encryption
    
    Authentication
    
    Integrity of messages
    
    Non-repudiation  senders cannot deny sending, and recipients cannot deny receiving,
messages
  
    
    Certified receipts
    
    Storage security
    
    Time stamps that cannot be repudiated
    
    Corporate policy enforcement
  ZixVPM, ZixVPM Alliance, and ZixVPM Corporate
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ZixAuditor
  ZixMail
  7




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ZixPort and ZixPort Corporate
   eHealth
 PocketScript
   Competition
  eSecure Competition
 8




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eHealth Competition
   Regulatory Drivers for Market Growth
   9




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Sales and Marketing
    Employees
  Research and Development; Patents and Trademarks
    10




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Availability of Raw Material; Working Capital Items
  Compliance with Environmental Regulations
  Governmental Contracts
  Significant Customers
  Sales Backlog
  December 31, 2005
    
    
    December 31, 2004Secure e-Messaging
    
    $
    19,849,000
    
    
    $
    13,100,000PocketScript
    
    
    2,092,000
    
    
    
    3,000,000Elron
    
    
    
    
    
    
    1,800,000MyDocOnline
    
    
    
    
    
    
    1,500,000Total backlog
    
    $
    21,941,000
    
    
    $
    19,400,000
    11




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Seasonality
  Geographic Information
  Available Information
   www.sec.gov.
 www.zixcorp.com.
 
 Item 1A. Risk Factors
 (In these risk factors, we, us, our, and ZixCorp refer to Zix Corporation and its
wholly-owned subsidiaries.)
 An investment in our common stock involves a high degree of risk. You should carefully
consider the following risk factors in evaluating an investment in our common stock. The risks
described below are not the only ones that we face. If any of the following risks actually occurs,
our business, financial condition, or results of operations could be materially and adversely
affected. In such case, the trading price of our common stock could decline, and you could lose
all or part of your investment. You should also refer to the other information set forth in this
report, including our consolidated financial statements and the related notes.
 We have incurred significant operating losses in previous years and we continue to use
significant amounts of cash for our business operations, which could result in us having
insufficient cash to fund our operations under our current business plan.
  12




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The market may not broadly accept our secure e-messaging and e-prescribing solutions and
services, which would prevent us from operating profitably.
  Failure to enter into additional or to maintain existing sponsorship agreements for our
PocketScript e-prescribing service and generate other revenue opportunities from PocketScript could
harm our business.
    Healthcare providers may fail to adopt our PocketScript service.
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Failure to significantly increase our base of PocketScript users or obtain significant
prescription transaction fees may result in failure to achieve the critical mass of physicians and
revenue to build a successful business.
    Competition in our businesses is expected to increase, which could cause our business to fail.
      Our inability to successfully and timely develop and introduce new e-messaging and
e-prescribing services and related services and to implement technological changes could harm our
business.
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If the market for secure e-messaging and e-prescribing services and related services does not
continue to grow, demand for our solutions and services will be adversely affected.
  Future asset impairments could affect our financial results.
   Capacity limits on our technology and network hardware and software may be difficult to
project, and we may not be able to expand and/or upgrade our systems to meet increased use, which
would result in reduced revenues.
 TM
 Security interruptions to our data centers could disrupt our business, and any security
breaches could expose us to liability and negatively impact customer demand for our solutions and
services.
   15




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® TM
 Pending litigation could have a material impact on our operating results and financial
condition.
    We may have to defend our rights in intellectual property that we use in our services, which
could be disruptive and expensive to our business.
  Defects or errors in our services could harm our business.
  16




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Public key cryptography technology is subject to risks.
  We depend on key personnel.
  We rely on third parties.
   We could be affected by government regulation.
    17




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Our stock price may be volatile.
  One investor owns a large percentage of our outstanding stock and could significantly
influence the outcome of actions.
  We have a certain amount of debt and may be unable to service or refinance this debt, or
servicing this debt may restrict cash available for our business operations, or complying with the
covenants of the debt could restrict certain desired business actions.
  
    
    result in our inability to comply with the financial and other restrictive covenants in
our outstanding convertible notes, which among other things, require us to maintain
specified cash levels and limit our ability to incur debt and sell assets, which could in
turn result in an event of default that, if not cured or waived, could have a material
adverse effect on our operations;
    
    require us to dedicate a substantial portion of our cash flow from operations to make
scheduled principal payments on our debt or to meet required cash reserves, thereby reducing
the availability of our cash flow for working capital, capital investments, and other
business activities;
    
    increase our vulnerability to adverse industry and general economic conditions;
    
    limit our ability to obtain additional financing to fund future working capital, capital
investments, and other business activities;
    
    limit our ability to refinance our indebtedness on terms that are commercially
reasonable; and
    
    limit our flexibility to plan for, and react to, changes in our business and our
industry.
 We have a significant amount of convertible securities and related warrants outstanding and
may issue additional equity securities in the future. Conversion or redemption of our outstanding
convertible note into our common stock, exercise of the outstanding warrants, and future issuances
or conversion of other securities will dilute the ownership interests of existing shareholders.
  18




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We may have liability for indemnification claims arising from the sale of our Web
Inspector ® , Message Inspector ® , and Dr.
Chart ® product lines.
  We may encounter other risks.
   NOTE ON FORWARD-LOOKING STATEMENTS AND RISK FACTORS
   19




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Item 1B. Unresolved Staff Comments
  
 Item 2. Properties
  
 Item 3. Legal Proceedings
     
 Item 4. Submission of Matters to Vote of Security Holders
  20




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i.e.,
 BROKERFOR
    
    AGAINST
    
    ABSTAIN
    
    NON-VOTES11,716,682
    
    
    1,118,195
    
    
    
    80,678
    
    
    
    21,421,229
  NOMINEE
    
    FOR
    
    WITHHELDRobert C. Hausmann
    
    
    33,454,426
    
    
    
    882,358Charles N. Kahn III
    
    
    33,529,489
    
    
    
    807,295Paul E. Schlosberg
    
    
    33,475,160
    
    
    
    861,624
 
 PART II
 
 Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of
Equity Securities
  2005
    
    2004Quarter Ended
    
    High
    
    Low
    
    High
    
    LowMarch 31
    
    $
    5.34
    
    
    $
    2.67
    
    
    $
    17.50
    
    
    $
    8.04June 30
    
    $
    3.92
    
    
    $
    2.50
    
    
    $
    18.55
    
    
    $
    6.33September 30
    
    $
    3.84
    
    
    $
    1.94
    
    
    $
    7.95
    
    
    $
    3.81December 31
    
    $
    2.50
    
    
    $
    1.50
    
    
    $
    6.25
    
    
    $
    3.84
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Item 6. Selected Financial Data
  Year Ended December 31,2005
    
    2004
    
    2003
    
    2002
    
    2001(In thousands, except per share data)Statement of Operations Data:Revenues(1)
    
    $
    13,964
    
    
    $
    14,127
    
    
    $
    5,840
    
    
    $
    1,672
    
    
    $
    317Cost of revenues(2)
    
    
    (14,194
    )
    
    
    (15,878
    )
    
    
    (8,211
    )
    
    
    (8,999
    )
    
    
    (14,996
    )Research and development expenses(2)
    
    
    (6,520
    )
    
    
    (9,331
    )
    
    
    (5,896
    )
    
    
    (6,180
    )
    
    
    (9,019
    )Selling, general and administrative
expenses(2)
    
    
    (26,358
    )
    
    
    (29,399
    )
    
    
    (19,907
    )
    
    
    (19,335
    )
    
    
    (29,892
    )Customer Deposit Forfeiture(3)
    
    
    960
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net Loss on Sale of Product Lines(4)
    
    
    (3,716
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Loss on Extinguishment of Convertible
Debt(5)
    
    
    (1,283
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Asset impairment charge(6)
    
    
    (288
    )
    
    
    (675
    )
    
    
    
    
    
    
    
    
    
    
    Interest expense(7)
    
    
    (6,848
    )
    
    
    (801
    )
    
    
    (13
    )
    
    
    (2,141
    )
    
    
    Loss from continuing operations
    
    
    (43,596
    )
    
    
    (42,040
    )
    
    
    (27,667
    )
    
    
    (34,299
    )
    
    
    (56,794
    )Basic and diluted loss per common share
from continuing operations(8)
    
    
    (1.20
    )
    
    
    (1.33
    )
    
    
    (1.23
    )
    
    
    (2.07
    )
    
    
    (3.32
    )Shares used in computing basic and
diluted loss per common share
    
    
    36,452
    
    
    
    31,533
    
    
    
    23,525
    
    
    
    18,129
    
    
    
    17,083Balance Sheet Data:Working capital(11)
    
    
    9,348
    
    
    
    4,913
    
    
    
    7,283
    
    
    
    13,668
    
    
    
    17,266Total assets
    
    
    34,115
    
    
    
    52,242
    
    
    
    26,419
    
    
    
    21,000
    
    
    
    32,436Debt obligations(9)
    
    
    7,063
    
    
    
    19,252
    
    
    
    
    
    
    
    
    
    
    
    Convertible preferred stock(10)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,653
    
    
    
    Stockholders, equity
    
    
    10,397
    
    
    
    14,765
    
    
    
    17,919
    
    
    
    11,545
    
    
    
    27,529
 
 The Company acquired substantially all of the operating assets and the businesses of
PocketScript, Elron Software, and MyDocOnline in July and September of 2003, and January 2004,
respectively. The results of operations of PocketScript, Elron Software, and MyDocOnline are
included in the Companys results of operations from their dates of acquisition. On March 11,
2005, the MI/WI product lines, which were acquired in the Elron acquisition, were sold to
CyberGuard (see Note 4 to the consolidated financial statements). On September 30, 2005, the Dr.
Chart product line was sold to MITEM (see Note 4 to the consolidated financial statements). During
2000 and extending through the third quarter of 2003, the Companys reporting classification was
that of a development stage company.Notes on Selected Financial Data(1)
    
    Revenues were insignificant during years 2001 and 2002. The respective increases in revenue
were mainly due to the nature of the Companys subscription-based secure e-messaging business,
which is experiencing renewal rates of 95% combined with continued additions of new customers.
Revenue growth was further bolstered by the acquisitions of MyDocOnline in January 2004 and
PocketScript and Elron Software in July and September 2003. Increased revenues resulting from
these acquisitions totaled $4.0 million, $4.2 million and $1.3 million in 2005, 2004 and 2003,
respectively. On March 11, 2005, the MI/WI product lines, which were acquired in the Elron
acquisition, were sold to CyberGuard. During 2005, the MI/WI product lines contributed $0.6
million to total revenues (see Note 4 to the consolidated financial statements) versus
revenues in 2004 and 2003 of $4.1 million and $1.3 million respectively. On September 30,
2005, the Dr. Chart product line was sold to MITEM. During 2005, this product line
contributed $0.3 million to total revenues (see Note 4 to the consolidated financial
statements) versus revenues in 2004 of $0.5 million.(2)
    
    In 2005, 2004, 2003, 2002, and 2001, expenses associated with continuing operations include
non-cash stock-based compensation of $1.1 million, $4.1 million, $1.0 million, $2.5 million,
and $8.4 million, respectively. These were often in association with reductions in force and
related severance agreements. In 2001, cost of revenues includes a $3 million write-off of
digital identification certificates. Selling, general, and administrative expenses include
advertising costs of $0.8 million, $0.7 million, $1.4 million, $2.9 million, and $4.5 million
for 2005, 2004, 2003, 2002, and 2001, respectively. 22




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(3)
    
    A Master Services Agreement was entered into with Aventis for $4.0 million on January 30,
2004, for the Companys performance of various future services. The services were to be
delivered in minimum amounts of $1.0 million, $1.0 million, and $2.0 million prior to January
30, 2005, January 30, 2006, and January 30, 2007 respectively. The services are to be defined
on an ongoing basis over the life of the agreement and valued in accordance with pricing for
similar services rendered by the Company for other customers. Aventis paid the $4.0 million
upon execution of the Master Services Agreement. Subsequent to the MyDocOnline acquisition,
Aventis merged with Sanofi and the rights under this agreement were transferred to the new
company, Sanofi-Aventis. Sanofi-Aventis has expressed to the ZixCorp that after the merger,
the combined company would have other focuses and they forfeited the remaining 2005 element of
the deposit for that year totaling $0.96 million (see Note 10 to the consolidated financial
statements).(4)
    
    On March 11, 2005, the Company sold its MI/WI product lines to CyberGuard. The net gained
realized on the sale was $1.0 million. On September 30, 2005, the Company sold its Dr. Chart
product line to MITEM. The net loss recognized on the sale was $4.8 million. The combined
impact of these transactions is a net loss of $3.7 million for 2005. (see Note 4 to the
consolidated financial statements)(5)
    
    On December 30, 2005, the Company transacted an early extinguishment of 50% of the
outstanding balance of the convertible notes payable (see Note 11 to the consolidated
financial statements). The total loss on the extinguishment of debt was $1.3 million.(6)
    
    In 2005, the Company recorded a $0.3 million asset impairment charge on certain fixed assets
that were not being utilized and had no identifiable value to the Company (see Note 7 to the
consolidated financial statements). In 2004, the Company shutdown all activity associated
with its Connect product. As a result, an impairment of the developed technology asset was
recognized for $0.7 million (see Notes 4 and 8 to the consolidated financial statements).(7)
    
    In 2005, interest expense includes charges of $6.4 million related to the Companys $20
million in convertible notes and related warrants issued on November 2, 2004. The interest
expense from the initial purchase agreement included amortization of the warrants value as a
discount on the notes, deferred finance charges and stated interest. In 2005, the Company
restructured the notes and created a beneficial conversion feature which was valued at $2.5
million and fully amortized in 2005 (see Note 11 to the consolidated financial statements).In 2004, interest expense also included charges of $0.5 million, which relates to the $20
million aggregate convertible notes. In 2002, interest expense included a charge of $1.7
million representing the beneficial conversion feature resulting from the issuance of notes
payable convertible into shares of common stock at an effective price less than the fair market
value of the common stock on the date the notes were issued.(8)
    
    In calculating the basic and diluted loss per common share for 2003 and 2002, the Companys
loss from continuing operations and net loss have been increased by $1.4 million and $3.2
million, respectively, representing the preferred stock dividends associated with the Series A
and Series B convertible preferred stocks.(9)
    
    Debt obligations at December 31, 2005 consist of convertible promissory notes payable
totaling $4.4 million, promissory notes payable totaling $2.2 million, a short-term promissory
note totaling $0.3 million and capital leases totaling $0.2 million. All notes payable are
shown net of unamortized discounts. December 31, 2004 balance consisted of convertible
promissory notes payable totaling $17.2 million, promissory note payable totaling $1.8
million, and capital leases totaling $0.2 million (see Note 11 to the consolidated financial
statements).(10)
    
    With regards to the outstanding shares in 2002, all of these shares and related accrued
dividends were converted throughout 2003 into shares of the Companys common stock.(11)
    
    Working capital includes customer deposits and deferred revenue totaling $8.1 million, both
as of December 31, 2005. 23




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Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
 Overview
       
    
    New subscriptions (termed new first year orders) for the Secure Messaging solution
    
    Renewal rates for the Secure Messaging service
    
    New insurance payor sponsorships of the PocketScript service to physicians
    
    Successful adoption and usage of the PocketScript service by physicians
    
    Retention of the users (physicians) of the PocketScript service
    
    Future transaction fees (or related fees) associated with the use of the PocketScript service
    
    The ability to increase the business volume with reasonable cost increases
 24




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Critical Accounting Policies and Estimates
  Long-Lived Assets
     Goodwill and Other Intangible Assets
 25




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Deferred Tax Assets
  Revenue Recognition
 Software Revenue Recognition, Modification of SOP 97-2, Software Revenue Recognition, With respect to Certain Transactions, Revenue Arrangements with Multiple
Deliverables, Revenue
Recognition in Financial Statements,
   26




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Deferred Cost of Revenue
  27




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##### Table of Contents



Full Year 2005 Summary of Operations
 Financial Statement
 
    
    Revenue for the year 2005 was $13,964,000 from all products compared with $14,127,000 in
2004 and $5,840,000 in 2003.
    
    Revenue from the two core products of Secure Messaging and PocketScript was $12,988,000
in 2005 compared with $9,603,000 in 2004 and $3,538,000 in 2003 for the same two products.
    
    Net loss for the year 2005 was $43,596,000 compared with $42,040,000 in 2004 and
$27,578,000 in 2003.
    
    Ending unrestricted cash balance was $20,240,000 and the balance in restricted accounts
was $5,135,000 on December 31, 2005.
    
    The Company significantly reduced debt with a combination of cash and issuances of the
Companys common stock, going from $19,463,000 of debt at December 31, 2004 to $7,308,000
of debt at December 31, 2005.
 Cost Reductions (Headcount Reductions)
 
    
    The Company had full time headcount of 215 on December 31, 2005 compared to 270 on December 31, 2004.
 o
    
    Headcount was reduced by 17 due to the product divestitures discussed below.o
    
    Headcount was reduced by 38 as a cost reduction effort in early 2005.
 Sale of Businesses
 
    
    On March 11, 2005, the Company sold its Web Inspector and Message Inspector product
lines (MI/WI) to CyberGuard for $3,244,000 net of transactions fees of $317,000. The
Company realized a $1,035,000 gain on the sale.
    
    On September 30, 2005, the Company sold the remaining MyDocOnline product (Dr. Chart) to
MITEM. As consideration, the Company received $150,000 in cash paid immediately after
closing, a promissory note with an original principal amount of $550,000 (subject to
certain adjustments) payable by mid-August 2007, and a warrant exercisable for 400,000
shares of MITEM common stock. The Company realized a $4,751,000 loss on the sale.
 Private Placement of Common Stock and Warrants
 
    
    On August 9, 2005, the Company entered into a Securities Purchase Agreement (the
Purchase Agreement) with certain purchasers (collectively, the Purchasers) to issue and
sell an aggregate of 10,503,862 units consisting of (i) one share of common stock of the
Company, par value $0.01 per share (the Common Stock), and (ii) a related warrant to
purchase one-third of one share of Common Stock. Total proceeds from the private placement
were $26,288,000 before transaction costs of $2,087,000.
 Redemption of 2004 Convertible Notes
 
    
    In April 2005, the Company entered into amendments with the holders of the Companys
$20,000,000 convertible promissory notes to restructure the original purchase agreements
signed on November 2, 2004. The restructuring resulted in the Company recording an
additional discount of $2,518,000 relating to a beneficial conversion feature in the
amended notes. This amount was fully amortized into interest expense during 2005.
    
    The Company made all payments and redemptions required by the restructured convertible
promissory notes throughout 2005. The required 2005 payments and redemptions included
$10,000,000 of principal ($8,049,000 redeemed in stock, $1,951,000 paid in cash), $500,000
of early payment premium ($402,000 redeemed in stock, $98,000 paid in cash), and $1,204,000
of interest ($922,000 redeemed in stock, $282,000 paid in cash). The Company issued
5,274,133 shares of common stock during 2005 to pay the convertible promissory notes,
prepayment premiums and related interest.
 28




---



##### Table of Contents




    
    On December 30, 2005, the Company transacted an early extinguishment of 50% of the
remaining outstanding balance of the convertible promissory notes ($5,000,000) utilizing
restricted cash. As part of the partial debt extinguishment the Company paid a 5% early
payment premium and all accrued interest. The Company recorded a loss on the
extinguishment of debt of $1,283,000.
 Results of Operations
 Revenues
    Variance
    
    
    VarianceYear Ended December 31,
    
    
    2005 vs. 2004
    
    
    2004 vs. 20032005
    
    
    2004
    
    
    2003
    
    
    $
    
    
    %
    
    
    $
    
    
    %Services
    
    $
    13,412,000
    
    
    $
    11,282,000
    
    
    $
    5,134,000
    
    
    $
    2,130,000
    
    
    
    19
    %
    
    $
    6,148,000
    
    
    
    120
    %Hardware
    
    
    443,000
    
    
    
    1,519,000
    
    
    
    
    
    
    
    (1,076,000
    )
    
    
    (71
    %)
    
    
    1,519,000
    
    
    NASoftware
    
    
    109,000
    
    
    
    1,326,000
    
    
    
    706,000
    
    
    
    (1,217,000
    )
    
    
    (92
    %)
    
    
    620,000
    
    
    
    88
    %Total revenues
    
    $
    13,964,000
    
    
    $
    14,127,000
    
    
    $
    5,840,000
    
    
    $
    (163,000
    )
    
    
    (1
    %)
    
    $
    8,287,000
    
    
    
    142
    %
   Variance
    
    
    VarianceYear Ended December 31,
    
    
    2005 vs. 2004
    
    
    2004 vs. 20032005
    
    
    2004
    
    
    2003
    
    
    $
    
    
    %
    
    
    $
    
    
    %Secure Messaging
    
    $
    10,007,000
    
    
    $
    7,071,000
    
    
    $
    3,473,000
    
    
    $
    2,936,000
    
    
    
    42
    %
    
    $
    3,598,000
    
    
    
    104
    %PocketScript
    
    
    2,981,000
    
    
    
    2,532,000
    
    
    
    65,000
    
    
    
    449,000
    
    
    
    18
    %
    
    
    2,467,000
    
    
    NASubtotal before divested products or
services
    
    
    12,988,000
    
    
    
    9,603,000
    
    
    
    3,538,000
    
    
    
    3,385,000
    
    
    
    35
    %
    
    
    6,065,000
    
    
    
    172
    %Entrust and AOS Service Agreements
    
    
    
    
    
    
    
    
    
    
    1,052,000
    
    
    
    
    
    
    
    
    
    
    
    (1,052,000
    )
    
    
    (100
    %)MI/WI Products
    
    
    646,000
    
    
    
    4,073,000
    
    
    
    1,250,000
    
    
    
    (3,427,000
    )
    
    
    (84
    %)
    
    
    2,823,000
    
    
    
    226
    %Dr. Chart and Connect
    
    
    330,000
    
    
    
    451,000
    
    
    
    
    
    
    
    (121,000
    )
    
    
    (27
    %)
    
    
    451,000
    
    
    
    N/ASubtotal divested products or services
    
    
    976,000
    
    
    
    4,524,000
    
    
    
    2,302,000
    
    
    
    (3,548,000
    )
    
    
    (78
    %)
    
    
    2,222,000
    
    
    
    97
    %Total revenues
    
    $
    13,964,000
    
    
    $
    14,127,000
    
    
    $
    5,840,000
    
    
    $
    (163,000
    )
    
    
    (1
    %)
    
    $
    8,287,000
    
    
    
    142
    %
 29




---



##### Table of Contents



30




---



##### Table of Contents



Backlog, Orders, and Deployments
       31




---



##### Table of Contents



Customer Deposit
    Cost of Revenues
  32




---



##### Table of Contents



Variance
    
    VarianceYear Ended December 31,
    
    2005 vs. 2004
    
    2004 vs. 20032005
    
    2004
    
    2003
    
    $
    
    %
    
    $
    
    %Total cost of
revenues
    
    $
    14,194,000
    
    
    $
    15,878,000
    
    
    $
    8,211,000
    
    
    $
    (1,684,000
    )
    
    
    (11
    %)
    
    $
    7,667,000
    
    
    
    93
    %
    Research and Development Expenses
  33




---



##### Table of Contents



Variance
    
    VarianceYear Ended December 31,
    
    2005 vs. 2004
    
    2004 vs. 20032005
    
    2004
    
    2003
    
    $
    
    %
    
    $
    
    %Total research and
development expenses
    
    $
    6,520,000
    
    
    $
    9,331,000
    
    
    $
    5,896,000
    
    
    $
    (2,811,000
    )
    
    
    (30
    %)
    
    $
    3,435,000
    
    
    
    58
    %
    Selling, General and Administrative Expenses
   Variance
    
    VarianceYear Ended December 31,
    
    2005 vs. 2004
    
    2004 vs. 20032005
    
    2004
    
    2003
    
    $
    
    %
    
    $
    
    %Total selling, general
and administrative
expenses
    
    $
    26,358,000
    
    
    $
    29,399,000
    
    
    $
    19,907,000
    
    
    $
    (3,041,000
    )
    
    
    (10
    %)
    
    $
    9,492,000
    
    
    
    48
    %
   34




---



##### Table of Contents



Customer Deposit Forfeiture
   Gain / Loss on Sale of Product Lines
     Asset Impairment Charge
   35




---



##### Table of Contents



Interest Expense
  Stated
    
    
    
    
    
    
    
    
    
    
    Financing
    
    
    
    
    
    
    TotalInterest
    
    
    Discount
    
    
    Premium
    
    
    Cost
    
    
    Warrants
    
    
    Intereston Notes
    
    
    Amortization
    
    
    Accretion
    
    
    Amortization
    
    
    Issued
    
    
    Expense2005Convertible
promissory notes payable
    
    $
    1,152,000
    
    
    $
    3,909,000
    
    
    $
    500,000
    
    
    $
    816,000
    
    
    $
    47,000
    
    
    $
    6,424,000Promissory note payable
    
    
    
    
    
    
    386,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    386,000Short-term promissory notes
    
    
    7,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,000Capital Leases
    
    
    31,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    31,000Total interest expense
    
    $
    1,190,000
    
    
    $
    4,295,000
    
    
    $
    500,000
    
    
    $
    816,000
    
    
    $
    47,000
    
    
    $
    6,848,0002004Convertible
promissory notes payable
    
    $
    178,000
    
    
    $
    200,000
    
    
    $
    
    
    
    $
    107,000
    
    
    $
    
    
    
    $
    485,000Promissory note payable
    
    
    
    
    
    
    315,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    315,000Short-term promissory notes
    
    
    1,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,000Capital Leases
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total interest expense
    
    $
    179,000
    
    
    $
    515,000
    
    
    $
    
    
    
    $
    107,000
    
    
    $
    
    
    
    $
    801,000
     Investment and Other Income
  36




---



##### Table of Contents



Recovery of Previously Impaired Investment
  Income Taxes
   Loss from Continuing Operations
   Year Ended
    
    
    Year Ended
    
    
    Year EndedDecember 31,
    
    
    December 31,
    
    
    December 31,2005
    
    
    2004
    
    
    2003Unusual Items:(Gain) or Loss on sale of product lines:Gain on sale of MI/WI
    
    $
    (1,035,000
    )
    
    $
    
    
    
    $
    Loss on sale of Dr. Chart
    
    
    4,751,000
    
    
    
    
    
    
    
    Customer deposit forfeiture
    
    
    (960,000
    )
    
    
    
    
    
    
    Asset impairment charge
    
    
    288,000
    
    
    
    675,000
    
    
    
    Recovery of previously impaired asset
    
    
    
    
    
    
    (70,000
    )
    
    
    (530,000
    )Discontinued Operations
    
    
    
    
    
    
    
    
    
    
    (89,000
    )Loss on extinguishment of convertible debt
    
    
    1,283,000
    
    
    
    
    
    
    
    Total unusual items
    
    $
    4,327,000
    
    
    $
    605,000
    
    
    $
    (619,000
    )
  Discontinued Operations
  37




---



##### Table of Contents



Liquidity and Capital Resources
 Overview
       
    
    New subscriptions (termed new first year orders) for the Secure Messaging solution
    
    Renewal rates for the Secure Messaging service
    
    New insurance payor sponsorships of the PocketScript service to physicians
    
    Successful adoption and usage of the PocketScript service by physicians
 38




---



##### Table of Contents




    
    Retention of the users (physicians) of the PocketScript service
    
    Future transaction fees (or related fees) associated with the use of the PocketScript service
    
    The ability to increase the business volume with reasonable cost increases
      39




---



##### Table of Contents



Sources and Uses of Cash Summary
   Twelve
    
    
    TwelveMonths
    
    
    Months
    
    
    Variance forEnded
    
    
    Ended
    
    
    the twelveDecember
    
    
    December
    
    
    month31, 2005
    
    
    31, 2004
    
    
    periodsOperating Cash Receipts (Products existing on December 31, 2005)
    
    $
    15,412,000
    
    
    $
    12,333,000
    
    
    $
    3,079,000Operating Cash Receipts (Products divested in 2005)
    
    
    1,760,000
    
    
    
    5,287,000
    
    
    
    (3,527,000
    )Customer Deposit Received
    
    
    (8,000
    )
    
    
    3,968,000
    
    
    
    (3,976,000
    )Net Operating Cash Spending
    
    
    (42,065,000
    )
    
    
    (44,355,000
    )
    
    
    2,290,000Net Cash Used by Operating Activities
    
    $
    (24,901,000
    )
    
    $
    (22,767,000
    )
    
    $
    (2,134,000
    )
    40




---



##### Table of Contents



Cash Sources
  Backlog 
 Continued Growth of Secure e-Messaging Business 
 New e-Prescribing Payors 
 41




---



##### Table of Contents



e-Prescribing usage based fees 
 Cash Requirements
    Debt Instruments and Related Covenants
  1.
    
    Convertible Promissory Notes Payable: $5,000,0002.
    
    Promissory Note Payable: $2,700,0003.
    
    Short-term Promissory Notes: $268,000
 Convertible Promissory Notes Payable
  42




---



##### Table of Contents



Promissory Note Payable
 Short-term Promissory Notes
 Liquidity Summary
    
    
    Relatively low contractual spending commitments in 2006
    
    Historically high renewal rates for Secure Messaging
    
    Continued growth in the Secure Messaging business
    
    Increased mix of cash receipts attributable to the more profitable out years of contracts
    
    The discretionary nature of the cash spend in excess of cash receipts in the emerging area of e-prescribing
    
    General flexibility of spending in other areas
  43




---



##### Table of Contents



Options and Warrants of ZixCorp Common Stock
  Summary of Outstanding Options and WarrantsVested SharesTotal Value
    
    
    (included in
    
    
    Total ValueOutstanding
    
    
    of Outstanding
    
    
    outstanding
    
    
    of VestedExercise Price Range
    
    Shares
    
    
    Shares
    
    
    shares)
    
    
    Shares$  1.44  $  4.99
    
    
    7,532,833
    
    
    $
    25,355,000
    
    
    
    2,770,838
    
    
    $
    9,860,000$  5.00  $  5.75
    
    
    3,118,224
    
    
    
    16,415,000
    
    
    
    3,067,128
    
    
    
    16,159,000$  6.00  $  8.89
    
    
    1,783,830
    
    
    
    11,945,000
    
    
    
    1,350,497
    
    
    
    9,263,000$  9.00  $19.75
    
    
    1,611,062
    
    
    
    17,387,000
    
    
    
    1,222,886
    
    
    
    13,351,000$21.38  $57.60
    
    
    1,138,695
    
    
    
    60,574,000
    
    
    
    1,138,695
    
    
    
    60,573,000Total
    
    
    15,184,644
    
    
    $
    131,676,000
    
    
    
    9,550,044
    
    
    $
    109,206,000
 Off-Balance Sheet Arrangements
  Contractual Obligations and Contingent Liabilities and Commitments
  Payments Due by PeriodTotal
    
    
    < 1 Year
    
    
    2-3 Year
    
    
    4-5 Years
    
    
    > 5 YearsDebt (long-term and short-term)
    
    $
    7,968,000
    
    
    $
    5,268,000
    
    
    $
    2,700,000
    
    
    $
    
    
    
    $
    Operating leases
    
    
    8,832,000
    
    
    
    1,397,000
    
    
    
    2,263,000
    
    
    
    1,845,000
    
    
    
    3,327,000Capital lease
    
    
    165,000
    
    
    
    165,000
    
    
    
    
    
    
    
    
    
    
    
    Total cash obligations
    
    
    16,965,000
    
    
    
    6,830,000
    
    
    
    4,963,000
    
    
    
    1,845,000
    
    
    
    3,327,000Interest on obligations
    
    
    514,000
    
    
    
    358,000
    
    
    
    156,000
    
    
    
    
    
    
    
    Total
    
    $
    17,479,000
    
    
    $
    7,188,000
    
    
    $
    5,119,000
    
    
    $
    1,845,000
    
    
    $
    3,327,000
     44




---



##### Table of Contents



Recent Accounting Pronouncements
 Share-Based Payment, .
     SFAS No. 154 Accounting Changes and Error Corrections Accounting Changes and Error Corrections Reporting Accounting Changes in Interim Financial Statements
 
 Item 7A. Quantitative and Qualitative Disclosures About Market Risk
   45




---



##### Table of Contents



Item 8. Financial Statements and Supplementary Data
  
 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
  
 Item 9A. Controls and Procedures
 Evaluation of Disclosure Controls and Procedure
 Annual Report on Form 10-K ,
 Managements Report on Internal Control Over Financial Reporting
  Internal Control  Integrated Framework
 Changes in Internal Controls over Financial Reporting
  46




---



##### Table of Contents



Report of Independent Registered Public Accounting Firm
 
 Internal ControlIntegrated Framework
    Internal ControlIntegrated Framework Internal ControlIntegrated Framework
   
 47




---



##### Table of Contents



Item 9B. Other Information
  
 PART III
 
 Item 10. Directors and Executive Officers of the Registrant
   www.zixcorp.com
 
 Item 11. Executive Compensation
  
 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters
  
 Item 13. Certain Relationships and Related Transactions
  
 Item 14. Principal Accounting Fees and Services
  
 PART IV
 
 Item 15. Exhibits, Financial Statement Schedule
 Financial Statements
  Financial Statement Schedules
  48




---



##### Table of Contents



Exhibits
 ExhibitNumber
    
    
    
    Description2.1
    
    
    
    Asset Purchase Agreement, dated as of January 30, 2004, by and among Zix
Corporation, MyDocOnline, Inc., Aventis Pharmaceuticals Holdings Inc., and
Aventis Pharmaceuticals Inc. (excluding schedules and exhibits). Filed as Exhibit
2.1 to Zix Corporations Current Report on Form 8-K, dated February 10, 2004, and
incorporated herein by reference.2.2
    
    
    
    Asset Purchase Agreement, dated July 22, 2003, between Zix Corporation and Pocket
Script L.L.C. (excluding schedules and exhibits). Filed as Exhibit 4.1 to Zix
Corporations Current Report on Form 8-K, dated July 23, 2003, and incorporated
herein by reference.2.3
    
    
    
    Asset Purchase Agreement, dated September 2, 2003, among Zix Corporation, Zix
Acquisition Corporation, Elron Software, Inc., Elron Electronic Industries, Ltd.,
and Elron Software (2000), Ltd. (excluding schedules and exhibits). Filed as
Exhibit 4.1 to Zix Corporations Current Report on Form 8-K, dated September 4,
2003, and incorporated herein by reference.2.4
    
    
    
    Asset Purchase Agreement, entered into as of March 11, 2005, by and between
CyberGuard Corporation and Zix SCM, Inc. (excluding the Disclosure Schedule and
Annexes). Filed as Exhibit 2.1 to Zix Corporations Current Report on Form 8-K,
dated March 17, 2005, and incorporated herein by reference.2.5
    
    
    
    Asset Purchase Agreement, entered into as of September 30, 2005, among Mitem
Corporation, Zix Corporation, and MyDocOnline, Inc. (excluding the Disclosure
Schedule and Exhibits). Filed as Exhibit 2.1 to Zix Corporations Current Report
on Form 8-K, dated October 5, 2005, and incorporated herein by reference.3.1*
    
    
    
    Restated Articles of Incorporation of Zix Corporation, as filed with the Texas
Secretary of State on November 10, 2005.3.2
    
    
    
    Restated Bylaws of Zix Corporation, dated October 30, 2002. Filed as Exhibit 3.2
to Zix Corporations Quarterly Report on Form 10-Q for the quarterly period ended
September 30, 2002, and incorporated herein by reference.4.1
    
    
    
    Specimen certificate for common stock of Zix Corporation. Filed as Exhibit 4.1
to Zix Corporations Annual Report on Form 10-K for the year ended December 31,
1999, and incorporated herein by reference.4.2
    
    
    
    Form of Warrant, dated June 24, 2003, to purchase shares of common stock of Zix
Corporation, issued by Zix Corporation. Filed as Exhibit 4.2 to Zix
Corporations Current Report on Form 8-K, dated June 25, 2003, and incorporated
herein by reference.4.3
    
    
    
    Warrant, dated as of January 30, 2004, of Zix Corporation to Aventis Holdings
Inc. for the purchase of 145,853 shares of Zix Corporations common stock. Filed
as Exhibit 4.4 to Zix Corporations Current Report on Form 8-K, dated February
10, 2004, and incorporated herein by reference.4.4
    
    
    
    Warrant to purchase 166,667 shares of common stock of Zix Corporation issued by
Zix Corporation to Rodman & Renshaw, LLC., dated as of November 2, 2004. Filed
as Exhibit 4.1 to Zix Corporations Quarterly Report on Form 10-Q for the
quarterly period ended March 31, 2005, and incorporated herein by reference.4.5
    
    
    
    Form of Common Stock Purchase Warrant, dated as of November 2, 2004, issued by
Zix Corporation to Omicron Master Trust and Amulet Limited. Filed as Exhibit 4.4
to Zix Corporations Current Report on Form 8-K, dated November 4, 2004, and
incorporated herein by reference.
 49




---



##### Table of Contents



ExhibitNumber
    
    
    
    Description4.6
    
    
    
    Form of Amended and Restated Common Stock Purchase Warrant to purchase shares of
Zix Corporation issued to Omicron Master Trust and Amulet Limited (excluding
exhibits). Filed as Exhibit 4.4 to Zix Corporations Current Report on Form 8-K,
dated April 14, 2005, and incorporated herein by reference.4.7
    
    
    
    Form of Warrant, dated August 9, 2005, to purchase shares of Common Stock of Zix
Corporation (including appendices) (issued in connection with the $26.3 million
private placement). Filed as Exhibit 4.2 to Zix Corporations Current Report on
Form 8-K, dated August 9, 2005, and incorporated herein by reference.4.8
    
    
    
    Warrant, dated September 30, 2005, issued by Mitem Corporation exercisable for
400,000 shares of common stock of Mitem Corporation. Filed as Exhibit 2.3 to Zix
Corporations Current Report on Form 8-K, dated October 5, 2005, and incorporated
herein by reference.4.9
    
    
    
    Convertible Promissory Note of Zix Corporation, dated September 2, 2003, in the
original principal amount of $1,000,000 issued to Elron Electronic Industries
Ltd. Filed as Exhibit 4.2 to Zix Corporations Current Report on Form 8-K, dated
September 4, 2003, and incorporated herein by reference.4.10
    
    
    
    Secured Promissory Note of Zix Corporation to Aventis Inc., dated January 30,
2004, in the original principal amount of $3,000,000. Filed as Exhibit 4.1 to Zix
Corporations Current Report on Form 8-K, dated February 10, 2004, and
incorporated herein by reference.4.11
    
    
    
    Security Agreement, dated as of January 30, 2004, by and between Zix Corporation
and Aventis Inc. Filed as Exhibit 4.3 to Zix Corporations Current Report on Form
8-K, dated February 10, 2004, and incorporated herein by reference.4.12
    
    
    
    Security Agreement, dated as of November 2, 2004, made by Zix Corporation to Law
Offices of Brian W. Pusch, as collateral agent on behalf of the holders named
therein. Filed as Exhibit 4.6 to Zix Corporations Current Report on Form 8-K,
dated November 4, 2004, and incorporated herein by reference.4.13
    
    
    
    Promissory Note, dated March 11, 2005, payable by CyberGuard Corporation in the
original principal amount of $1,500,000. Filed as Exhibit 2.2 to Zix
Corporations Current Report on Form 8-K, dated March 17, 2005, and incorporated
herein by reference.4.14
    
    
    
    Form of Amended and Restated Convertible Note Due 2005-2008 of Zix Corporation
payable to Omicron Master Trust and Amulet Limited (including exhibits) (issued
in connection with the $20 million private placement). Filed as Exhibit 4.3 to
Zix Corporations Current Report on Form 8-K, dated April 14, 2005, and
incorporated herein by reference.4.15
    
    
    
    Promissory Note, dated September 30, 2005, payable by Mitem Corporation in the
original principal amount of $550,000. Filed as Exhibit 2.2 to Zix Corporations
Current Report on Form 8-K, dated October 5, 2005, and incorporated herein by
reference.4.16
    
    
    
    Registration Rights Agreement, dated June 24, 2003, by and among Zix Corporation
and the investors named therein (issued in connection with the $5.75 million
financing). Filed as Exhibit 4.3 to Zix Corporations Current Report on Form
8-K, dated June 25, 2003, and incorporated herein by reference.4.17
    
    
    
    Registration Rights Agreement, dated July 22, 2003, between Zix Corporation and
Pocket Script, L.L.C. Filed as Exhibit 4.2 to Zix Corporations Current Report on
Form 8-K, dated July 23, 2003, and incorporated herein by reference.4.18
    
    
    
    Registration Rights Agreement, dated September 2, 2003, between Zix Corporation
and Elron Software,
Inc. Filed as Exhibit 4.3 to Zix Corporations Current Report
on Form 8-K, dated September 4, 2003, and incorporated herein by reference.4.19
    
    
    
    Registration Rights Agreement, dated January 30, 2004, by and among Zix
Corporation, Aventis
 50




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##### Table of Contents



ExhibitNumber
    
    
    
    DescriptionInc., a Pennsylvania corporation, and Aventis Holdings Inc.,
a Delaware corporation. Filed as Exhibit 4.2 to Zix Corporations Current Report
on Form 8-K, dated February 10, 2004, and incorporated herein by reference.4.20
    
    
    
    Form of Registration Rights Agreement, dated as of November 2, 2004, by and
between Zix Corporation and the Investors named therein (issued in connection
with the $20 million private placement). Filed as Exhibit 4.5 to Zix
Corporations Current Report on Form 8-K, dated November 4, 2004, and
incorporated herein by reference.4.21
    
    
    
    Form of Amended and Restated Registration Rights Agreement by and between Zix
Corporation and the Investors (excluding exhibits) (issued in connection with the
$20 million private placement). Filed as Exhibit 4.5 to Zix Corporations
Current Report on Form 8-K, dated April 14, 2005, and incorporated herein by
reference.4.22
    
    
    
    Securities Purchase Agreement, dated June 24, 2003, by and among Zix Corporation
and the investors named therein (including schedules but excluding exhibits)
(issued in connection with the $5.75 million financing). Filed as Exhibit 4.1 to
Zix Corporations Current Report on Form 8-K, dated June 25, 2003, and
incorporated herein by reference.4.23
    
    
    
    Securities Purchase Agreement, dated as of August 9, 2005, by and between Zix
Corporation and the Purchasers listed on Schedule A thereto (including schedules,
appendices and exhibits) (issued in connection with the $26.3 million private
placement). Filed as Exhibit 4.1 to Zix Corporations Current Report on Form
8-K/A, dated October 21, 2005, and incorporated herein by reference.4.24
    
    
    
    Letter Agreement, dated September 12, 2004, amending the Master Services
Agreement, dated January 30, 2004, by and between Zix Corporation and Aventis
Inc. Filed as Exhibit 10.37 to Zix Corporations Annual Report on Form 10-K for
the year ended December 31, 2004, and incorporated herein by reference.4.25
    
    
    
    Purchase Agreement, dated as of November 1, 2004, by and between Zix Corporation
and Omicron Master Trust (excluding schedules and exhibits). Filed as Exhibit 4.1
to Zix Corporations Current Report on Form 8-K, dated November 4, 2004, and
incorporated herein by reference.4.26
    
    
    
    Amendment No. 1 to Purchase Agreement, dated as of April 13, 2005, by and between
Zix Corporation and Omicron Master Trust (excluding schedules and exhibits).
Filed as Exhibit 4.1 to Zix Corporations Current Report on Form 8-K, dated April
14, 2005, and incorporated herein by reference.4.27
    
    
    
    Amendment No. 2, dated as of December 9, 2005, by and between Zix Corporation and
Omicron Master Trust Relating to Amended and Restated Convertible Note Due
2005-2008 and Amended and Restated Common Stock Purchase Warrant. Filed as
Exhibit 4.1 to Zix Corporations Current Report on Form 8-K, dated December 12,
2005, and incorporated herein by reference.4.28
    
    
    
    Purchase Agreement, dated as of November 1, 2004, by and between Zix Corporation
and Amulet Limited (excluding schedules and exhibits). Filed as Exhibit 4.2 to
Zix Corporations Current Report on Form 8-K, dated November 4, 2004, and
incorporated herein by reference.4.29
    
    
    
    Amendment No. 1 to Purchase Agreement, dated as of April 13, 2005, by and between
Zix Corporation and Amulet Limited (excluding schedules and exhibits). Filed as
Exhibit 4.2 to Zix Corporations Current Report on Form 8-K, dated April 14,
2005, and incorporated herein by reference.4.30
    
    
    
    Amendment No. 2, dated as of December 9, 2005, by and between Zix Corporation and
Amulet Limited Relating to Amended and Restated Convertible Note Due 2005-2008
and Amended and Restated Common Stock Purchase Warrant. Filed as Exhibit 4.2 to
Zix Corporations Current Report on Form 8-K, dated December 12, 2005, and
incorporated herein by reference.4.31
    
    
    
    Escrow Agreement, dated as of August 9, 2005, by and between Zix Corporation and
JPMorgan Chase Bank, N.A, as escrow agent (including exhibits and schedules).
Filed as Exhibit 10.1 to Zix
 51




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##### Table of Contents



ExhibitNumber
    
    
    
    DescriptionCorporations Current Report on Form 8-K/A, dated
October 21, 2005, and incorporated herein by reference.10.1
    
    
    
    1990 Stock Option Plan of Zix Corporation (Amended and Restated as of September
1999). Filed as Exhibit 10.1 to Zix Corporations Quarterly Report on Form 10-Q
for the quarterly period ended September 30, 1999, and incorporated herein by
reference.10.2
    
    
    
    1992 Stock Option Plan of Zix Corporation (Amended and Restated as of August
2000). Filed as Exhibit 10.2 to Zix Corporations Annual Report on Form 10-K for
the year ended December 31, 2003, and incorporated herein by reference.10.3
    
    
    
    1995 Long-Term Incentive Plan of Zix Corporation (Amended and Restated as of
September 20, 2000). Filed as Exhibit 10.3 to Zix Corporations Quarterly Report
on Form 10-Q for the quarterly period ended September 30, 2000, and incorporated
herein by reference.10.4
    
    
    
    1996 Employee Stock Purchase Plan of Zix Corporation (Amended and Restated as of
July 1, 2000). Filed as Exhibit 10.2 to Zix Corporations Quarterly Report on
Form 10-Q for the quarterly period ended June 30, 2000, and incorporated herein
by reference.10.5
    
    
    
    Zix Corporation 1999 Directors Stock Option Plan (Amended and Restated as of
August 1, 2002). Filed as Exhibit 10.1 to Zix Corporations Quarterly Report on
Form 10-Q for the quarterly period ended June 30, 2002, and incorporated herein
by reference.10.6
    
    
    
    Zix Corporation 2001 Employee Stock Option Plan, dated May 4, 2001. Filed as
Exhibit 10.1 to Zix Corporations Quarterly Report on Form 10-Q for the quarterly
period ended March 31, 2001, and incorporated herein by reference.10.7
    
    
    
    Zix Corporations 2001 Stock Option Plan (Amended and Restated as of May 6,
2003). Filed as Exhibit 10.7 to Zix Corporations Annual Report on Form 10-K for
the year ended December 31, 2003, and incorporated herein by reference.10.8
    
    
    
    Zix Corporation 2003 Stock Compensation Plan (Amended and Restated in October
2003). Filed as Exhibit 10.1 to Zix Corporations Quarterly Report on Form 10-Q
for the quarterly period ended September 30, 2003, and incorporated herein by
reference.10.9
    
    
    
    Zix Corporations 2003 New Employee Stock Option Plan, dated October 1, 2003.
Filed as Exhibit 10.9 to Zix Corporations Annual Report on Form 10-K for the
year ended December 31, 2003, and incorporated herein by reference.10.10
    
    
    
    Zix Corporation 2004 Stock Option Plan, dated May 6, 2004. Filed as Exhibit 10.1
to Zix Corporations Quarterly Report on Form 10-Q for the quarterly period ended
March 31, 2004, and incorporated herein by reference.10.11
    
    
    
    Zix Corporation 2004 Stock Option Plan (Amended and Restated as of May 25, 2005).
Filed as Exhibit 10.1 to Zix Corporations Registration Statement on Form S-8
(Registration No. 333-126576), dated July 13, 2005, and incorporated herein by
reference.10.12
    
    
    
    Zix Corporation 2004 Directors Stock Option Plan, dated May 6, 2004. Filed as
Exhibit 10.2 to Zix Corporations Quarterly Report on Form 10-Q for the quarterly
period ended March 31, 2004, and incorporated herein by reference.10.13
    
    
    
    Zix Corporation 2005 Stock Compensation Plan (Adopted Effective as of May 25,
2005). Filed as Exhibit 10.1 to Zix Corporations Registration Statement on Form
S-8 (Registration No. 333-126571), dated July 13, 2005, and incorporated herein
by reference.10.14
    
    
    
    Form of Stock Option Agreement (with no change in control provision) for Zix
Corporation 2004 Stock Option Plan. Filed as Exhibit 10.2 to Zix Corporations
Registration Statement on Form S-8 (Registration No. 333-126576), dated July 13,
2005, and incorporated herein by reference.
 52




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##### Table of Contents



ExhibitNumber
    
    
    
    Description10.15
    
    
    
    Form of Stock Option Agreement (with change in control provision) for Zix
Corporation 2004 Stock Option Plan. Filed as Exhibit 10.3 to Zix Corporations
Registration Statement on Form S-8 (Registration No. 333-126576), dated July 13,
2005, and incorporated herein by reference.10.16
    
    
    
    Zix Corporation 401(k) Retirement Plan. Filed as Exhibit 10.10 to Zix
Corporations Annual Report on Form 10-K for the year ended December 31, 2003,
and incorporated herein by reference.10.17
    
    
    
    Adoption Agreement relating to Zix Corporation 401(k) Retirement Plan. Filed as
Exhibit 10.11 to Zix Corporations Annual Report on Form 10-K for the year ended
December 31, 2003, and incorporated herein by reference.10.18
    
    
    
    Stock Option Agreement, effective as of November 14, 2001, between John Ryan and
Zix Corporation. Filed as Exhibit 4.2 in Zix Corporations Registration Statement
on Form S-8 (Registration No. 333-74890), dated December 11, 2001, and
incorporated herein by reference. Portions of this exhibit were omitted pursuant
to a request for confidential treatment that was filed with the SEC on November
26, 2001. On December 5, 2001, the SEC approved the filing of this exhibit
omitting the portions for which confidential treatment was requested. The omitted
information has been filed with the SEC.10.19
    
    
    
    Employment Agreement, entered into as of January 20, 2004, between Zix
Corporation and Richard Spurr. Filed as Exhibit 10.14 to Zix Corporations Annual
Report on Form 10-K for the year ended December 31, 2003, and incorporated herein
by reference.10.20
    
    
    
    Employment Offer Letter of Zix Corporation, dated March 23, 2005, to Richard D.
Spurr. Filed as Exhibit 10.1 to Zix Corporations Quarterly Report on Form 10-Q
for the quarterly period ended March 31, 2005, and incorporated herein by
reference.10.21
    
    
    
    Stock Option Agreement, dated February 24, 2004, between Zix Corporation and
Richard Spurr. Filed as Exhibit 10.15 to Zix Corporations Annual Report on Form
10-K for the year ended December 31, 2003, and incorporated herein by reference.10.22
    
    
    
    Stock Option Agreement, dated November 17, 2004, between Zix Corporation and
Richard D. Spurr. Filed as Exhibit 10.18 to Zix Corporations Annual Report on
Form 10-K for the year ended December 31, 2004, and incorporated herein by
reference.10.23
    
    
    
    Stock Option Agreement, dated March 23, 2005, between Zix Corporation and Richard
D. Spurr. Filed as Exhibit 10.2 to Zix Corporations Quarterly Report on Form
10-Q for the quarterly period ended March 31, 2005, and incorporated herein by
reference.10.24
    
    
    
    Form of Zix Corporation Stock Option Agreement between Zix Corporation and Brad
Almond and Ronald A. Woessner. Filed as Exhibit 10.19 to Zix Corporations
Annual Report on Form 10-K for the year ended December 31, 2004, and incorporated
herein by reference.10.25
    
    
    
    Form of Outside Director Stock Option Agreement, dated January 2, 2004, between
Zix Corporation and James S. Marston, Dr. Ben G. Streetman and Michael E. Keane.
Filed as Exhibit 10.3 to Zix Corporations Quarterly Report on Form 10-Q for the
quarterly period ended June 30, 2004, and incorporated herein by reference.10.26
    
    
    
    Outside Director Stock Option Agreement, dated May 6, 2004, between Zix
Corporation and Antonio R. Sanchez III. Filed as Exhibit 10.4 to Zix
Corporations Quarterly Report on Form 10-Q for the quarterly period ended June
30, 2004, and incorporated herein by reference.10.27
    
    
    
    Severance Agreement, dated February 25, 2002, between Zix Corporation and Ronald
A. Woessner. Filed as Exhibit 10.18 to Zix Corporations Annual Report on Form
10-K for the year ended December 31, 2001, and incorporated herein by reference.10.28
    
    
    
    Form of Severance Agreement between Zix Corporation and certain executive
officers. Filed as Exhibit 10.2 to Zix Corporations Quarterly Report on Form
10-Q for the quarterly period ended March 31, 2002, and incorporated herein by
reference.
 53




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##### Table of Contents



ExhibitNumber
    
    
    
    Description10.29
    
    
    
    Description of Compensation for Members of Zix Corporation Board of Directors.
Filed as Exhibit 10.24 to Zix Corporations Annual Report on Form 10-K for the
year ended December 31, 2004, and incorporated herein by reference.10.30
    
    
    
    Lease Agreement, dated December 29, 2003, between Zix Corporation and 7-Eleven,
Inc. (excluding exhibits) (relating to Zix Corporations Dallas, Texas
facilities). Filed as Exhibit 10.24 to Zix Corporations Annual Report on Form
10-K for the year ended December 31, 2003, and incorporated herein by reference.10.31
    
    
    
    Office Lease Agreement, dated February 28, 2005, between Gateway Rosewood, Inc.
and Zix SCM, Inc. (relating to Zix Corporations Burlington, Massachusetts
facility). Filed as Exhibit 10.26 to Zix Corporations Annual Report on Form
10-K for the year ended December 31, 2004, and incorporated herein by reference.10.32
    
    
    
    Lease Agreement, dated November 27, 2000, between MyDocOnline, Inc. and Ft. Round
Rock Ltd. and related Amendments No. 1 and No. 2 (excluding exhibits) (relating
to Zix Corporations Austin, Texas facility). Filed as Exhibit 10.27 to Zix
Corporations Annual Report on Form 10-K for the year ended December 31, 2003,
and incorporated herein by reference.10.33
    
    
    
    Amendment No. 3 to Lease Agreement, dated November 27, 2000, between MyDocOnline,
Inc. and Ft. Round Rock Ltd., as amended (relating to Zix Corporations Austin,
Texas facility). Filed as Exhibit 10.28 to Zix Corporations Annual Report on
Form 10-K for the year ended December 31, 2004, and incorporated herein by
reference.10.34
    
    
    
    Facilities Service Agreement, entered into as of June 25, 2003, by and between
Collocation Solutions, LLC and Zix Corporation (excluding schedule and exhibit).
Filed as Exhibit 10.33 to Zix Corporations Annual Report on Form 10-K for the
year ended December 31, 2003, and incorporated herein by reference.10.35
    
    
    
    Lease, dated March 9, 2004, between Duke Realty Ohio and PocketScript, Inc.
(excluding exhibits) (relating to Zix Corporations Mason, Ohio facility). Filed
as Exhibit 10.34 to Zix Corporations Annual Report on Form 10-K for the year
ended December 31, 2003, and incorporated herein by reference.10.36
    
    
    
    Master Services Agreement, dated January 30, 2004, by and between Zix Corporation
and Aventis Inc. Filed as Exhibit 10.1 to Zix Corporations Current Report on
Form 8-K, dated February 10, 2004, and incorporated herein by reference. Portions
of this exhibit were omitted and filed separately with the SEC pursuant to a
request for confidential treatment filed with the SEC.10.37
    
    
    
    Amendment No. 2 to Master Services Agreement, dated March 7, 2005, between Zix
Corporation and Aventis Inc. and a member of the Sanofi-Aventis Group. Filed as
Exhibit 10.38 to Zix Corporations Annual Report on Form 10-K for the year ended
December 31, 2004, and incorporated herein by reference.10.38
    
    
    
    Office Center Sub-Lease, dated September 28, 2005, including an addendum, dated
October 5, 2005, between American Exec Cupertino, Inc. (dba American Executive
Center) and Zix Corporation. Filed as Exhibit 10.2 to Zix Corporations
Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2005,
and incorporated herein by reference.10.39
    
    
    
    Sublease Agreement between ZixCorp Canada, Inc. and Intelligent Photonics Control
Corp., dated May 20, 2005 (relating to Zix Corporations Ontario, Canada
facility). Filed as Exhibit 10.1 to Zix Corporations Quarterly Report on Form
10-Q for the quarterly period ended June 30, 2005, and incorporated herein by
reference.10.40*
    
    
    
    Amendment and Confirmation of Sublease, dated February 27, 2006, amongst Elk
Property Management Limited (Landlord), Intelligent Photonics Control Corp.
(Tenant), 6447309 Canada Inc. (Assignee), ZixCorp Canada, Inc. and Zix
Corporation (excluding schedules).
 54




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##### Table of Contents



ExhibitNumber
    
    
    
    Description10.41*
    
    
    
    Description of Zix Corporation 2006 Management Variable Compensation Plan.16.1
    
    
    
    Letter From Ernst & Young LLP to the SEC. Filed as Exhibit 16.1 to Zix
Corporations Current Report on Form 8-K, dated June 23, 2004, and incorporated
herein by reference.17.1
    
    
    
    Letter of John A. Ryan, Resignation From Board of Directors, dated October 21,
2005. Filed as Exhibit 17.1 to Zix Corporations Current Report on Form 8-K,
dated October 25, 2005, and incorporated herein by reference.21.1*
    
    
    
    Subsidiaries of Zix Corporation.23.1*
    
    
    
    Consent of Independent Registered Public Accounting Firm (Deloitte & Touche, LLP).23.2*
    
    
    
    Consent of Independent Registered Public Accounting Firm (Ernst & Young, LLP).31.1*
    
    
    
    Certification of Richard D. Spurr, President and Chief Executive Officer of the
Company, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2*
    
    
    
    Certification of Bradley C. Almond, Vice President, Chief Financial Officer, and
Treasurer of the Company, pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.32.1*
    
    
    
    Certification of Richard D. Spurr, President and Chief Executive Officer of the
Company and Bradley C. Almond, Vice President, Chief Financial Officer, and
Treasurer of the Company, pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
 
 *
    
    Filed herewith.
    
    Management contract or compensatory plan or arrangement. 55




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##### Table of Contents



SIGNATURES
   By: /s/ BRADLEY C. ALMONDBradley C. AlmondVice President,Chief Financial Officer and Treasurer
  Signature
    
    Title/s/ RICHARD D. SPURR
    
    Chairman, Chief Executive Officer,
President and Director(Richard D. Spurr)
    
    (Principal Executive Officer)/s/ BRADLEY C. ALMOND
    
    Vice President, Chief Financial
Officer and Treasurer(Bradley C. Almond)
    
    (Principal Financial and Accounting Officer)/s/ ROBERT C. HAUSMANN
    
    Director(Robert C. Hausmann)/s/ CHARLES N. KAHN III
    
    Director(Charles N. Kahn III)/s/ JAMES S. MARSTON
    
    Director(James S. Marston)/s/ ANTONIO R. SANCHEZ III
    
    Director(Antonio R. Sanchez III)/s/ PAUL E. SCHLOSBERG
    
    Director(Paul E. Schlosberg)/s/ DR. BEN G. STREETMAN
    
    Director(Dr. Ben G. Streetman)
 56




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##### Table of Contents



INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 Reports of Independent Registered Public Accounting Firms
    
    
    F-2Consolidated Balance Sheets at December 31, 2005 and 2004
    
    
    F-4Consolidated Statements of Operations for the years ended
December 31, 2005, 2004 and 2003
    
    
    F-5Consolidated Statements of Convertible Preferred Stock and
Stockholders Equity for the years ended December 31,
2005, 2004 and 2003
    
    
    F-6Consolidated Statements of Cash Flows for the years ended
December 31, 2005, 2004 and 2003
    
    
    F-7Notes to Consolidated Financial Statements
    
    
    F-8
 F-1




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##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
    Internal Control 
Integrated Framework
  
 F-2




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##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
     
 F-3




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##### Table of Contents



ZIX CORPORATION
 
 CONSOLIDATED BALANCE SHEETS
 December 31,2005
    
    
    2004ASSETSCurrent assets:Cash and cash equivalents
    
    $
    20,240,000
    
    
    $
    3,856,000Marketable securities
    
    
    
    
    
    
    16,000,000Restricted cash
    
    
    5,100,000
    
    
    
    Receivables, net
    
    
    149,000
    
    
    
    561,000Prepaid and other current assets
    
    
    1,845,000
    
    
    
    1,950,000Total current assets
    
    
    27,334,000
    
    
    
    22,367,000Restricted cash
    
    
    35,000
    
    
    
    10,374,000Property and equipment, net
    
    
    3,652,000
    
    
    
    5,024,000Intangible assets, net
    
    
    559,000
    
    
    
    3,832,000Goodwill
    
    
    2,161,000
    
    
    
    9,119,000Deferred financing costs and other assets
    
    
    374,000
    
    
    
    1,526,000Total assets
    
    $
    34,115,000
    
    
    $
    52,242,000LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,313,000
    
    
    $
    1,234,000Accrued expenses
    
    
    3,749,000
    
    
    
    4,709,000Deferred revenue
    
    
    7,087,000
    
    
    
    6,372,000Customer deposit
    
    
    1,000,000
    
    
    
    968,000Capital lease obligations
    
    
    165,000
    
    
    
    130,000Short-term note payable
    
    
    268,000
    
    
    
    193,000Convertible promissory notes payable
    
    
    4,404,000
    
    
    
    3,848,000Total current liabilities
    
    
    17,986,000
    
    
    
    17,454,000Long-term liabilities:Deferred revenue
    
    
    1,261,000
    
    
    
    1,731,000Customer deposit
    
    
    2,000,000
    
    
    
    3,000,000Convertible promissory notes payable
    
    
    
    
    
    
    13,347,000Promissory note payable
    
    
    2,226,000
    
    
    
    1,840,000Deferred rent
    
    
    245,000
    
    
    
    18,000Capital lease obligations and other
    
    
    
    
    
    
    87,000Total long-term liabilities
    
    
    5,732,000
    
    
    
    20,023,000Total liabilities
    
    
    23,718,000
    
    
    
    37,477,000Commitments and contingencies (Note 16)Stockholders equity:Preferred stock, $1 par value, 10,000,000 shares authorized; none issued and
outstanding
    
    
    
    
    
    
    Common stock, $0.01 par value, 175,000,000 shares authorized;
51,932,561 issued and 49,605,380 outstanding in 2005 and
34,584,406 issued and 32,257,225 outstanding in 2004
    
    
    519,000
    
    
    
    346,000Additional paid-in capital
    
    
    308,461,000
    
    
    
    269,406,000Treasury stock, at cost; 2,327,181 common shares in 2005 and 2004
    
    
    (11,507,000
    )
    
    
    (11,507,000
    )Accumulated deficit
    
    
    (287,076,000
    )
    
    
    (243,480,000
    )Total stockholders equity
    
    
    10,397,000
    
    
    
    14,765,000$
    34,115,000
    
    
    $
    52,242,000
  F-4




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##### Table of Contents



ZIX CORPORATION
 
 CONSOLIDATED STATEMENTS OF OPERATIONS
 Year Ended December 31,2005
    
    
    2004
    
    
    2003Revenues:Services
    
    $
    13,412,000
    
    
    $
    11,282,000
    
    
    $
    5,134,000Hardware
    
    
    443,000
    
    
    
    1,519,000
    
    
    
    Software
    
    
    109,000
    
    
    
    1,326,000
    
    
    
    706,000Total revenues
    
    
    13,964,000
    
    
    
    14,127,000
    
    
    
    5,840,000Costs and expenses:Cost of revenues
    
    
    14,194,000
    
    
    
    15,878,000
    
    
    
    8,211,000Research and development expenses
    
    
    6,520,000
    
    
    
    9,331,000
    
    
    
    5,896,000Selling, general and administrative expenses
    
    
    26,358,000
    
    
    
    29,399,000
    
    
    
    19,907,000Customer deposit forfeiture
    
    
    (960,000
    )
    
    
    
    
    
    
    Net loss on sale of product lines
    
    
    3,716,000
    
    
    
    
    
    
    
    Asset impairment charge
    
    
    288,000
    
    
    
    675,000
    
    
    
    Total costs and expenses
    
    
    50,116,000
    
    
    
    55,283,000
    
    
    
    34,014,000Operating loss
    
    
    (36,152,000
    )
    
    
    (41,156,000
    )
    
    
    (28,174,000
    )Other (expense) income:Investment and other income
    
    
    776,000
    
    
    
    332,000
    
    
    
    138,000Interest expense
    
    
    (6,848,000
    )
    
    
    (801,000
    )
    
    
    (13,000
    )Loss on extinguishment of convertible debt
    
    
    (1,283,000
    )
    
    
    
    
    
    
    Recovery of previously impaired investment
    
    
    
    
    
    
    70,000
    
    
    
    530,000Total other (expense) income
    
    
    (7,355,000
    )
    
    
    (399,000
    )
    
    
    655,000Loss from continuing operations before income
taxes
    
    
    (43,507,000
    )
    
    
    (41,555,000
    )
    
    
    (27,519,000
    )Income taxes
    
    
    (89,000
    )
    
    
    (485,000
    )
    
    
    (148,000
    )Loss from continuing operations
    
    
    (43,596,000
    )
    
    
    (42,040,000
    )
    
    
    (27,667,000
    )Discontinued operations
    
    
    
    
    
    
    
    
    
    
    89,000Net loss
    
    $
    (43,596,000
    )
    
    $
    (42,040,000
    )
    
    $
    (27,578,000
    )Basic and diluted loss per common share:Continuing operations
    
    $
    (1.20
    )
    
    $
    (1.33
    )
    
    $
    (1.23
    )Discontinued operations
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    $
    (1.20
    )
    
    $
    (1.33
    )
    
    $
    (1.23
    )Basic and diluted weighted average common
shares outstanding
    
    
    36,452,000
    
    
    
    31,533,000
    
    
    
    23,525,077
  F-5




---



##### Table of Contents



ZIX CORPORATION
 
 CONSOLIDATED STATEMENTS OF CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS EQUITY
 Stockholders EquityConvertible Preferred
    
    
    
    
    
    
    
    
    
    
    Additional
    
    
    
    
    
    
    
    
    
    
    TotalStock
    
    
    Common Stock
    
    
    Paid-In
    
    
    Treasury
    
    
    Accumulated
    
    
 StockholdersShares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    Capital
    
    
    Stock
    
    
    Deficit
    
    
    EquityBalance, January 1, 2003
    
    
    2,012,274
    
    
    $
    5,653,000
    
    
    
    22,764,798
    
    
    $
    228,000
    
    
    $
    195,281,000
    
    
    $
    (11,507,000
    )
    
    $
    (172,457,000
    )
    
    $
    11,545,000Issuance of common stock upon exercise of stock options
    
    
    
    
    
    
    
    
    
    
    2,358,968
    
    
    
    23,000
    
    
    
    12,942,000
    
    
    
    
    
    
    
    
    
    
    
    12,965,000Series A convertible preferred stock converted into
common stock
    
    
    (765,559
    )
    
    
    (2,814,000
    )
    
    
    787,424
    
    
    
    8,000
    
    
    
    2,806,000
    
    
    
    
    
    
    
    
    
    
    
    2,814,000Series B convertible preferred stock converted into
common stock
    
    
    (1,246,715
    )
    
    
    (4,244,000
    )
    
    
    1,271,653
    
    
    
    13,000
    
    
    
    4,231,000
    
    
    
    
    
    
    
    
    
    
    
    4,244,000Dividends on Series A and Series B convertible preferred
Stock
    
    
    
    
    
    
    1,405,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,405,000
    )
    
    
    (1,405,000
    )Common stock and related warrants issued for cash in
private placements, net of issuance costs
    
    
    
    
    
    
    
    
    
    
    1,566,758
    
    
    
    16,000
    
    
    
    5,592,000
    
    
    
    
    
    
    
    
    
    
    
    5,608,000Common stock issued for purchase of PocketScript
    
    
    
    
    
    
    
    
    
    
    362,903
    
    
    
    3,000
    
    
    
    1,383,000
    
    
    
    
    
    
    
    
    
    
    
    1,386,000Common stock issued for purchase of Elron Software
    
    
    
    
    
    
    
    
    
    
    1,709,402
    
    
    
    17,000
    
    
    
    6,316,000
    
    
    
    
    
    
    
    
    
    
    
    6,333,000Promissory note payable converted into common stock
    
    
    
    
    
    
    
    
    
    
    262,454
    
    
    
    3,000
    
    
    
    1,010,000
    
    
    
    
    
    
    
    
    
    
    
    1,013,000Employee stock compensation expense
    
    
    
    
    
    
    
    
    
    
    71,286
    
    
    
    1,000
    
    
    
    483,000
    
    
    
    
    
    
    
    
    
    
    
    484,000Non-employee stock-based compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    550,000
    
    
    
    
    
    
    
    
    
    
    
    550,000Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (40,000
    )
    
    
    
    
    
    
    
    
    
    
    (40,000
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (27,578,000
    )
    
    
    (27,578,000
    )Balance, December 31, 2003
    
    
    
    
    
    
    
    
    
    
    31,155,646
    
    
    
    312,000
    
    
    
    230,554,000
    
    
    
    (11,507,000
    )
    
    
    (201,440,000
    )
    
    
    17,919,000Issuance of common stock upon exercise of stock options
    
    
    
    
    
    
    
    
    
    
    1,005,812
    
    
    
    10,000
    
    
    
    5,489,000
    
    
    
    
    
    
    
    
    
    
    
    5,499,000Issuance of common stock upon exercise of warrants
    
    
    
    
    
    
    
    
    
    
    1,379,746
    
    
    
    14,000
    
    
    
    15,329,000
    
    
    
    
    
    
    
    
    
    
    
    15,343,000Common stock issued for purchase of MyDocOnline
    
    
    
    
    
    
    
    
    
    
    583,411
    
    
    
    6,000
    
    
    
    9,031,000
    
    
    
    
    
    
    
    
    
    
    
    9,037,000Valuation of warrants assigned to promissory note payable
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,475,000
    
    
    
    
    
    
    
    
    
    
    
    1,475,000Valuation of warrants assigned to convertible promissory
Notes payable
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,511,000
    
    
    
    
    
    
    
    
    
    
    
    3,511,000Employee stock compensation expense
    
    
    
    
    
    
    
    
    
    
    459,791
    
    
    
    4,000
    
    
    
    3,890,000
    
    
    
    
    
    
    
    
    
    
    
    3,894,000Non-employee stock-based compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    179,000
    
    
    
    
    
    
    
    
    
    
    
    179,000Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (52,000
    )
    
    
    
    
    
    
    
    
    
    
    (52,000
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (42,040,000
    )
    
    
    (42,040,000
    )Balance, December 31, 2004
    
    
    
    
    
    
    
    
    
    
    34,584,406
    
    
    
    346,000
    
    
    
    269,406,000
    
    
    
    (11,507,000
    )
    
    
    (243,480,000
    )
    
    
    14,765,000Issuance of common stock and related warrants upon
private investment
    
    
    
    
    
    
    
    
    
    
    10,503,862
    
    
    
    105,000
    
    
    
    24,096,000
    
    
    
    
    
    
    
    
    
    
    
    24,201,000Issuance of common stock upon exercise of warrants
    
    
    
    
    
    
    
    
    
    
    1,209,712
    
    
    
    12,000
    
    
    
    2,076,000
    
    
    
    
    
    
    
    
    
    
    
    2,088,000Issuance of common stock upon exercise of stock options
    
    
    
    
    
    
    
    
    
    
    10,833
    
    
    
    
    
    
    
    28,000
    
    
    
    
    
    
    
    
    
    
    
    28,000Employee stock compensation expense
    
    
    
    
    
    
    
    
    
    
    349,615
    
    
    
    4,000
    
    
    
    1,008,000
    
    
    
    
    
    
    
    
    
    
    
    1,012,000Common stock issued in lieu of cash redemption of
convertible promissory notes
    
    
    
    
    
    
    
    
    
    
    4,856,129
    
    
    
    48,000
    
    
    
    8,403,000
    
    
    
    
    
    
    
    
    
    
    
    8,451,000Common stock issued in lieu of cash payments for
interest on convertible promissory notes
    
    
    
    
    
    
    
    
    
    
    418,004
    
    
    
    4,000
    
    
    
    918,000
    
    
    
    
    
    
    
    
    
    
    
    922,000Valuation of additional anti-dilutive warrants issued
upon private placement
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    153,000
    
    
    
    
    
    
    
    
    
    
    
    153,000Valuation of additional warrants issued upon retirement
of convertible promissory notes payable
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    146,000
    
    
    
    
    
    
    
    
    
    
    
    146,000Revaluation of outstanding warrants resulting from
restructure of convertible promissory note payable
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (375,000
    )
    
    
    
    
    
    
    
    
    
    
    (375,000
    )Valuation of beneficial conversion feature resulting
from the restructure of promissory note payable
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,518,000
    
    
    
    
    
    
    
    
    
    
    
    2,518,000Non-employee stock-based compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    110,000
    
    
    
    
    
    
    
    
    
    
    
    110,000Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (26,000
    )
    
    
    
    
    
    
    
    
    
    
    (26,000
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (43,596,000
    )
    
    
    (43,596,000
    )Balance, December 31, 2005
    
    
    
    
    
    
    
    
    
    
    51,932,561
    
    
    $
    519,000
    
    
    $
    308,461,000
    
    
    $
    (11,507,000
    )
    
    $
    (287,076,000
    )
    
    $
    10,397,000
  F-6




---



##### Table of Contents



ZIX CORPORATION
 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 Year Ended December 31,2005
    
    
    2004
    
    
    2003Operating activities:Net loss
    
    $
    (43,596,000
    )
    
    $
    (42,040,000
    )
    
    $
    (27,578,000
    )Non-cash items in net loss:Depreciation and amortization
    
    
    4,104,000
    
    
    
    4,820,000
    
    
    
    3,676,000Amortization of debt discount/premium, financing costs,
and other
    
    
    5,543,000
    
    
    
    622,000
    
    
    
    Valuation of additional warrants issued upon cash payment
of convertible debt
    
    
    47,000
    
    
    
    
    
    
    
    Loss on extinguishment of convertible debt
    
    
    1,283,000
    
    
    
    
    
    
    
    Acquired in-process research and development
    
    
    
    
    
    
    306,000
    
    
    
    Asset impairment charge
    
    
    288,000
    
    
    
    675,000
    
    
    
    Employee stock compensation expense
    
    
    1,012,000
    
    
    
    3,894,000
    
    
    
    484,000Common stock issued in lieu of cash interest payments
    
    
    922,000
    
    
    
    
    
    
    
    Non-employee stock-based compensation
    
    
    110,000
    
    
    
    179,000
    
    
    
    550,000Customer deposit forfeiture
    
    
    (960,000
    )
    
    
    
    
    
    
    Loss on sale of product lines
    
    
    3,716,000
    
    
    
    
    
    
    
    Recovery of investment in Maptuit Corporation and other
    
    
    
    
    
    
    (70,000
    )
    
    
    (517,000
    )Changes in operating assets and liabilities, excluding
effects of acquisitions:Accounts receivable
    
    
    365,000
    
    
    
    (1,000
    )
    
    
    1,039,000Other assets
    
    
    362,000
    
    
    
    (492,000
    )
    
    
    601,000Accounts payable
    
    
    51,000
    
    
    
    718,000
    
    
    
    89,000Deferred revenue
    
    
    2,628,000
    
    
    
    3,201,000
    
    
    
    2,985,000Customer deposits
    
    
    (8,000
    )
    
    
    3,968,000
    
    
    
    Accrued and other liabilities
    
    
    (768,000
    )
    
    
    1,453,000
    
    
    
    (110,000
    )Net cash used by operating activities
    
    
    (24,901,000
    )
    
    
    (22,767,000
    )
    
    
    (18,781,000
    )Investing activities:Purchases of property and equipment
    
    
    (1,734,000
    )
    
    
    (3,393,000
    )
    
    
    (2,252,000
    )Purchases of marketable securities
    
    
    
    
    
    
    (35,582,000
    )
    
    
    (11,951,000
    )Sales and maturities of marketable securities
    
    
    16,000,000
    
    
    
    26,564,000
    
    
    
    11,944,000Purchase of restricted cash investment
    
    
    (35,000
    )
    
    
    (10,103,000
    )
    
    
    Proceeds from restricted cash investments
    
    
    5,274,000
    
    
    
    
    
    
    
    Proceeds from sale of product lines
    
    
    3,262,000
    
    
    
    
    
    
    
    Cash received from Maptuit Corporation
    
    
    
    
    
    
    70,000
    
    
    
    530,000Purchase of PocketScript and MyDocOnline
    
    
    
    
    
    
    (282,000
    )
    
    
    (50,000
    )Cash acquired in the purchase of Elron Software
    
    
    
    
    
    
    
    
    
    
    1,000,000Net cash provided by (used in) investing activities
    
    
    22,767,000
    
    
    
    (22,726,000
    )
    
    
    (779,000
    )Financing activities:Proceeds from private placement of common stock
    
    
    26,288,000
    
    
    
    
    
    
    
    5,750,000Payment of expenses relating to private placement of common
stock
    
    
    (2,057,000
    )
    
    
    
    
    
    
    (142,000
    )Proceeds from exercise of stock options
    
    
    28,000
    
    
    
    5,499,000
    
    
    
    12,965,000Proceeds from exercise of warrants
    
    
    2,088,000
    
    
    
    15,343,000
    
    
    
    Payment of short term note payable, capital lease, and other
    
    
    (530,000
    )
    
    
    
    
    
    
    Payment of premium on convertible debt
    
    
    (348,000
    )
    
    
    
    
    
    
    Payment of convertible debt
    
    
    (6,951,000
    )
    
    
    
    
    
    
    Proceeds from promissory note payable
    
    
    
    
    
    
    3,000,000
    
    
    
    Proceeds from convertible promissory notes, net of issuance
costs
    
    
    
    
    
    
    18,908,000
    
    
    
    Net cash provided by financing activities
    
    
    18,518,000
    
    
    
    42,750,000
    
    
    
    18,573,000Increase (decrease) in cash and cash equivalents
    
    
    16,384,000
    
    
    
    (2,743,000
    )
    
    
    (987,000
    )Cash and cash equivalents, beginning of year
    
    
    3,856,000
    
    
    
    6,599,000
    
    
    
    7,586,000Cash and cash equivalents, end of year
    
    $
    20,240,000
    
    
    $
    3,856,000
    
    
    $
    6,599,000
  F-7




---



##### Table of Contents



ZIX CORPORATION
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 1. Company Overview and Liquidity
       F-8




---



##### Table of Contents



F-9




---



##### Table of Contents



2. Summary of Significant Accounting Policies
 Consolidation
 Use of Estimates
 Cash Equivalents, Restricted Cash and Marketable Securities
  Property and Equipment, Long-Lived and Other Intangible Assets, Depreciation and Amortization
   Goodwill
 F-10




---



##### Table of Contents



Goodwill and Other Intangible Assets
  Deferred Tax Assets
 Leases
 Revenue Recognition Software Revenue
Recognition, Modification of SOP 97-2, Software Revenue Recognition, With respect to
Certain Transactions, Revenue Arrangements
with Multiple Deliverables, Revenue Recognition in Financial Statements,
  F-11




---



##### Table of Contents



Customer Indemnification Guarantees
 F-12




---



##### Table of Contents



Warranty Costs
 Deferred Cost of Revenue
 Software Development Costs
  Advertising Expense
 Stock Based Compensation Accounting for Stock-Based Compensation, Accounting for Stock Issued to
Employees
  2005
    
    
    2004
    
    
    2003Net loss, as reported
    
    $
    (43,596,000
    )
    
    $
    (42,040,000
    )
    
    $
    (27,578,000
    )Add employee stock compensation expense recorded
under the intrinsic value method
    
    
    
    
    
    
    1,115,000
    
    
    
    Deduct pro forma stock compensation expense
computed under the fair value method
    
    
    (6,166,000
    )
    
    
    (9,214,000
    )
    
    
    (4,502,000
    )Pro forma net loss
    
    $
    (49,762,000
    )
    
    $
    (50,139,000
    )
    
    $
    (32,080,000
    )Basic and diluted pro forma loss per common Share
    
    $
    (1.37
    )
    
    $
    (1.59
    )
    
    $
    (1.42
    )
  F-13




---



##### Table of Contents



2005
    
    2004
    
    2003Risk-free interest rate
    
    
    3.41
    %
    
    
    1.86
    %
    
    
    1.77
    %Expected option life
    
    3.6 years
    
    
    2.5 years
    
    
    2.5 yearsExpected stock price volatility
    
    
    96
    %
    
    
    108
    %
    
    
    103
    %Expected dividend yield
    
    
    
    
    
    
    
    
    
    
    Fair value of options granted
    
    $
    2.31
    
    
    $
    4.23
    
    
    $
    2.63
 Share-Based Payment, Accounting for Stock-Based Compensation Accounting for Stock Issued to Employees.
     Earnings Per Share
 Comprehensive Loss
 Other Recent Accounting Pronouncements
 F-14




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##### Table of Contents



SFAS No. 154 Accounting Changes and Error Corrections Accounting Changes and Error Corrections Reporting Accounting Changes in Interim Financial Statements
 3. Supplemental Cash Flow Information
  Year Ended December 31,2005
    
    
    2004
    
    
    2003Cash interest paid
    
    $
    389,000
    
    
    $
    1,000
    
    
    $
    Income tax payment
    
    $
    261,000
    
    
    $
    163,000
    
    
    $
    Supplemental schedule of noncash investing and financing
activities:Common stock issued for purchase of MyDocOnline (see Note 4)
    
    $
    
    
    
    $
    9,037,000
    
    
    $
    Issuance of warrants related to convertible promissory notes payable
(see Note 11)
    
    $
    
    
    
    $
    3,511,000
    
    
    $
    Issuance of warrants related to promissory note payable (see Note 11)
    
    $
    
    
    
    $
    1,475,000
    
    
    $
    Assets acquired on capital lease
    
    $
    160,000
    
    
    $
    213,000
    
    
    $
    Payables related to purchases of assets
    
    $
    34,000
    
    
    $
    
    
    
    $
    Insurance premiums financed by short-term note payable (see Note 11)
    
    $
    367,000
    
    
    $
    193,000
    
    
    $
    Stock redemption of convertible promissory notes payable (see Note
11)
    
    $
    8,451,000
    
    
    $
    
    
    
    $
    Valuation of
additional anti-dilutive warrants issued upon private placement
    
    $
    153,000
    
    
    $
    
    
    
    $
    Revaluation of warrants resulting from restructuring of convertible
promissory notes (see Note 11)
    
    $
    375,000
    
    
    $
    
    
    
    $
    Valuation of beneficial conversion feature resulting from
restructure of convertible promissory notes payable (see Note 11)
    
    $
    2,518,000
    
    
    $
    
    
    
    $
    Accrued expenses relating to private placement common stock (see
Note 12)
    
    $
    30,000
    
    
    $
    
    
    
    $
    Common stock issued for purchase of PocketScript (see Note 4)
    
    $
    
    
    
    $
    
    
    
    $
    1,386,000Common stock issued for purchase of Elron Software (see Note 4)
    
    $
    
    
    
    $
    
    
    
    $
    6,333,000Promissory note payable converted to common stock
    
    $
    
    
    
    $
    
    
    
    $
    1,013,000Accretion of dividends on Series A and B convertible preferred stock
    
    $
    
    
    
    $
    
    
    
    $
    1,405,000Conversion of Series A and B convertible preferred stock into common
stock
    
    $
    
    
    
    $
    
    
    
    $
    7,058,000
 4. Business Sales and Acquisitions
 MyDocOnline, Inc.
  F-15




---



##### Table of Contents



Fair market value of 583,411 shares of the Companys common stock
    
    $
    9,037,000Transaction costs
    
    
    282,000Total acquisition cost
    
    $
    9,319,000
   Working capital items:Receivables and prepaid expenses
    
    $
    354,000Deferred revenue
    
    
    (140,000
    )Net working capital acquired
    
    
    214,000Property and equipment
    
    
    1,293,000Customer relationships
    
    
    658,000Developed technology
    
    
    2,051,000Goodwill
    
    
    4,797,000In-process research and development
    
    
    306,000$
    9,319,000
      F-16




---



##### Table of Contents



Net assets sold (liabilities transferred):Accounts receivable, net
    
    $
    34,000Equipment, net
    
    
    37,000Intangibles, net
    
    
    575,000Deferred revenue
    
    
    (739,000
    )Net
    
    
    (93,000
    )Goodwill
    
    
    4,797,000Net proceeds:Cash receivable
    
    
    150,000Note receivable, net
    
    
    Service obligation
    
    
    (30,000
    )Transaction fees
    
    
    (167,000
    )Net proceeds
    
    
    (47,000
    )Loss on sale of product line
    
    $
    (4,751,000
    )
   Elron Software, Inc.
   Fair market value of 1,709,402 shares of the Companys
common stock
    
    $
    6,333,000Fair market value of the 5.75% $1,000,000 convertible
promissory note payable
    
    
    1,000,000Transaction costs
    
    
    136,000Total acquisition cost
    
    $
    7,469,000
   Working capital items:Cash
    
    $
    1,000,000Receivables and prepaid expenses
    
    
    587,000Accounts payable and accrued liabilities
    
    
    (487,000
    )Deferred revenue
    
    
    (776,000
    )Net working capital acquired
    
    
    324,000
 F-17




---



##### Table of Contents



Property and equipment
    
    
    113,000Developed technology
    
    
    943,000Customer contracts and relationships
    
    
    1,336,000Trademarks and trade names
    
    
    432,000Goodwill
    
    
    4,321,000$
    7,469,000
     Net assets sold (liabilities transferred):Equipment, net
    
    $
    15,000Prepaid expenses
    
    
    165,000Intangibles, net
    
    
    1,499,000Initial deferred revenue
    
    
    (1,546,000
    )Subsequent additional transfer of deferred revenue, net
    
    
    (85,000
    )Net
    
    
    48,000Goodwill
    
    
    2,161,000Net proceeds:Cash
    
    
    2,126,000Note receivable, net
    
    
    1,435,000Transaction fees
    
    
    (317,000
    )Net proceeds
    
    
    3,244,000Gain on sale of product lines
    
    $
    1,035,000
   F-18




---



##### Table of Contents



PocketScript, Inc.
   Cash payment
    
    $
    50,000Fair market value of 362,903 shares of the Companys common
stock
    
    
    1,386,000Transaction costs
    
    
    21,000Total acquisition cost
    
    $
    1,457,000
   Working capital items:Accounts payable
    
    $
    (40,000
    )Deferred revenue
    
    
    (175,000
    )Working capital deficit acquired
    
    
    (215,000
    )Property and equipment
    
    
    346,000Developed technology
    
    
    1,326,000$
    1,457,000
  Consolidated Pro Forma Information
  2003Revenues
    
    $
    11,167,000Net loss
    
    $
    (56,841,000
    )Preferred stock dividends (see Note 12)
    
    
    (1,405,000
    )Net loss applicable to common stock
    
    $
    (58,246,000
    )Basic and diluted loss per common share
    
    $
    (2.31
    )Weighted average shares used in per share calculation
    
    
    25,251,212
  F-19




---



##### Table of Contents



5. Restricted Cash and Marketable Securities
   6. Accounts Receivable
 December 312005
    
    
    2004Gross accounts receivable
    
    $
    3,153,000
    
    
    $
    3,732,000Allowance for returns and doubtful accounts
    
    
    (35,000
    )
    
    
    (74,000
    )Unpaid portion of deferred revenue
    
    
    (2,969,000
    )
    
    
    (3,097,000
    )Receivables, net
    
    $
    149,000
    
    
    $
    561,000
  7. Property and Equipment
 December 312005
    
    
    2004Computer equipment and software
    
    $
    31,627,000
    
    
    $
    32,467,000Leasehold improvements
    
    
    4,691,000
    
    
    
    4,581,000Office equipment, furniture and fixtures
    
    
    1,191,000
    
    
    
    1,333,00037,509,000
    
    
    
    38,381,000Less accumulated depreciation and amortization
    
    
    (33,857,000
    )
    
    
    (33,357,000
    )$
    3,652,000
    
    
    $
    5,024,000
    F-20




---



##### Table of Contents



8. Intangible Assets and Goodwill
  December 31, 2005
    
    
    December 31, 2004Accumulated
    
    
    
    
    
    
    
    
    
    
    AccumulatedCost
    
    
    Amortization
    
    
    Net
    
    
    Cost
    
    
    Amortization
    
    
    NetDeveloped
technology
    
    $
    2,034,000
    
    
    $
    1,475,000
    
    
    $
    559,000
    
    
    $
    3,541,000
    
    
    $
    1,347,000
    
    
    $
    2,194,000Customer contract and
relationships
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,994,000
    
    
    
    596,000
    
    
    
    1,398,000Trademarks and trade
names
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    432,000
    
    
    
    192,000
    
    
    
    240,000Total intangible
assets
    
    $
    2,034,000
    
    
    $
    1,475,000
    
    
    $
    559,000
    
    
    $
    5,967,000
    
    
    $
    2,135,000
    
    
    $
    3,832,000
    AccumulatedCost
    
    
    AmortizationBalance at January 1, 2004
    
    $
    4,037,000
    
    
    $
    448,000MyDocOnline acquisition
    
    
    2,709,000
    
    
    
    Asset impairment charge
    
    
    
    
    
    
    675,000Amortization of intangibles
    
    
    
    
    
    
    1,791,000Write-off of impaired asset
    
    
    (779,000
    )
    
    
    (779,000
    )Balance at December 31, 2004
    
    
    5,967,000
    
    
    
    2,135,000Amortization of intangibles
    
    
    
    
    
    
    1,199,000Sale of intangibles to CyberGuard
    
    
    (2,711,000
    )
    
    
    (1,212,000
    )Sale of intangibles to MITEM
    
    
    (1,222,000
    )
    
    
    (647,000
    )Ending balance at December 31, 2005
    
    $
    2,034,000
    
    
    $
    1,475,000
  2006
    
    $
    536,0002007
    
    
    23,000Total
    
    $
    559,000
   9. Accrued Expenses
 2005
    
    
    2004Employee compensation and benefits
    
    $
    1,766,000
    
    
    $
    2,056,000Professional fees
    
    
    615,000
    
    
    
    481,000Taxes
    
    
    800,000
    
    
    
    884,000Insurance
    
    
    
    
    
    
    160,000Interest
    
    
    64,000
    
    
    
    178,000Other
    
    
    504,000
    
    
    
    950,000Total accrued expenses
    
    $
    3,749,000
    
    
    $
    4,709,000
 F-21




---



##### Table of Contents



10. Customer Deposit
    11. Notes Payable
  AdditionalDiscount fromDecember 31,
    
    
    Debt
    
    
    
    
    
    
    Additional Debt
    
    
    December 31,Stated
    
    
    Effective
    
    
    
    
    
    
    2004
    
    
    Amendments /
    
    
    Discount /
    
    
    Incurred /
    
    
    2005Interest
    
    
    Interest
    
    
    
    
    
    
    Net Book
    
    
    Additional
    
    
    Premium
    
    
    (Payments
    
    
    Net BookRate
    
    
    Rate
    
    
    Term
    
    
    Value
    
    
    Warrants
    
    
    Amortization
    
    
    Made)
    
    
    ValueConvertible
promissory notes payable.
    
    
    7.47
    %
    
    
    29.75
    %
    
    
    2007
    
    
    $
    17,195,000
    
    
    $
    (2,296,000
    )
    
    $
    5,005,000
    
    
    $
    (15,500,000
    )
    
    $
    4,404,000Promissory note payable
    
    
    4.50
    %
    
    
    11.00
    %
    
    
    2007
    
    
    
    1,840,000
    
    
    
    
    
    
    
    386,000
    
    
    
    
    
    
    
    2,226,000Short-term
promissory notes
    
    
    6.99
    %
    
    
    6.99
    %
    
    
    2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    366,000
    
    
    
    193,000
    
    
    
    
    
    
    
    
    
    
    
    (291,000
    )
    
    
    268,000Total notes payable
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    19,228,000
    
    
    $
    (2,296,000
    )
    
    $
    5,391,000
    
    
    $
    (15,425,000
    )
    
    $
    6,898,000
 Convertible Promissory Notes Payable
  F-22




---



##### Table of Contents




    
    The principal is payable in four installments of $5,000,000 on October 31 and December
31, 2005 (collectivity, the 2005 Payments), November 2, 2006 and 2007.
    
    The 2005 Payments can be redeemed at 105% of principal and can be redeemed in stock, in
whole at any time or in part from time-to-time on or before the revised payment dates. The
redemption value of the stock is based on the daily VWAP of the common stock less a 10%
discount for 15 trading days preceding the date of stock redemption. The amount of stock
redeemed during any 15 day redemption period is limited to 20% of the volume of the
Companys stock traded in the public market. The Company may declare more than one stock
redemption before the October 31 and December 31, 2005 payment dates as long as the stock
redemptions are at least 20 trading days apart. Any portion of the 2005 payments which are
not or cannot be redeemed in stock must be paid in cash at 105% of principal.
    
    If the Company pays all or a portion of the 2005 payments in cash, the Company must issue
immediately exercisable warrants to the Investors equaling 70% of the common stock that
would be issued to the Investors to retire that portion of the principal paid in cash at
$6.00 per share (or lower exercise price if anti-dilution provisions are triggered). The
exercise price of these warrants, if issued, would be $6.00 (or lower exercise price if
anti-dilution provisions are triggered) and the warrants will expire on an annual basis
beginning on November 2, 2006 and ending on November 2, 2008. These warrants would
thereafter be subject to potential weighted average downward re-pricing triggered by future
equity issuance by the Company at a price lower than $6.00 per share. In the fourth quarter
2005 the exercise price was further lowered to $5.38 due to the private placement of common
stock (see Note 12).
    
    The 2006 and 2007 payments may be paid in stock if the Companys common stock closes
above $6.00 per share for 15 of 20 days before the payment date.
    
    The Company has the right to prepay the 2006 and 2007 payments at any time at 105% of the
outstanding principal amount of the notes, plus accrued interest if the Company is not in a
share deficiency situation. In addition, the Company must issue immediately exercisable
warrants to the Investors equaling 70% of the common stock that would be issued to the
Investors to retire the principal and interest assuming the notes and interest were
converted to the Companys common stock. The exercise price of these warrants, if issued,
would be $6.00 a share, or lower if anti-dilution clauses are triggered.
    
    The warrants to purchase 1,000,000 shares of the Companys common stock at an exercise
price of $6.00 per share, were amended, such that the exercise price for a pro-rata portion
of the warrants is reduced to the price of the Companys common stock as and when the
convertible notes are redeemed in stock, if the redemption value per share of common stock
is lower than $6.00 per share.
    
    The notes stated interest rate is the six-month LIBOR plus 300 basis points and is reset
every six months (this rate was reset on November 1, 2005 to 7.47%).
    
    At the Companys option, and assuming the Company has not reached the maximum shares
allowed under the notes, interest on the notes is payable quarterly in cash or common stock
valued at a 10% discount to the volume weighted average price (VWAP) for the Companys
common stock for a specified number of trading days preceding the interest payment date.
 F-23




---



##### Table of Contents




    
    The Investors may convert the notes into the Companys common stock at $6.00 a share at
any time. However, the Company has the right to force the conversion of the notes at $6.00
if the Companys common stock closes above $11.00 per share for 15 of 20 days before the
annual payment date and if the following conditions are met:
 1.
    
    no event of default or repurchase event, as such terms are defined in the
convertible notes, under the notes has occurred,2.
    
    there is an effective registration statement on file with the
SEC covering the shares of stock to be issued with respect to the payment of principal and the
registration statement has been effective during the 20 consecutive trading days
preceding the principal payment date and is reasonably expected to be effective for at
least 30 days following the issuance of the shares; and3.
    
    110% of the sum of the number of common stock shares to be issued to a particular
holder on the scheduled principal payment date, plus the number of common stock shares
previously issued to that holder, plus the number of common stock shares then issuable
upon conversion of the note held by that holder or exercise of the warrants held by that
holder is less than the portion of a maximum share amount allocated to such holder
(initially 3,407,801 shares for each original note holder).
 
    
    The notes have weighted average anti-dilution provisions that would cause an adjustment
to the conversion price and the number of shares issuable under the notes upon the
occurrence of issuances of equity securities or convertible equity securities at prices
below the then-effective conversion price or other specified dilutive events such as stock
splits, stock dividends, recapitalizations, certain repurchases by
the Company of its shares, and certain dividends and distributions made by the Company.
    
    The Investors have the right to require the Company to repurchase the notes in cash upon
the occurrence of specified repurchase events, such as a change in control or events of
default while the notes are outstanding. Additionally, the notes contain restrictive
covenants, including covenants that prohibit the Company from incurring certain
indebtedness, establishing certain liens on the Companys assets or issuing any variable
priced securities.
    
    The Company was required to place certain proceeds from the notes into a restricted
collateral account. The amount of restricted cash collateral required to be maintained in
this account is 50% of the aggregate principal amount outstanding (initially $10,000,000).
The Company was required to maintain an overall cash balance of $10,000,000 (restricted and
non-restricted) through December 31, 2005 at which time the required cash balance would be
reduced $9,000,000 at the time the December 31, 2005 payment is made. The required cash
balance will further decrease to $5,000,000 in November 2006 through the notes maturity when
the November 2, 2006 payment is made.
 Accounting treatment of the amended convertible promissory notes payable
 Accounting for Derivative Financial instruments Indexed to, and Potentially Settled in a
Companys Own Stock Accounting for Convertible Debt
and Debt Issued with Stock Purchase Warrants.
 Accounting for
Convertible Securities with Beneficial Conversion Features of Contingently Adjustable Conversion
Features Application of Issue No. 98-5 to Certain Convertible
Instruments
 F-24




---



##### Table of Contents



2005 adjustment to the stock conversion price and warrant exercise price
 2005 Payment Activity on the Convertible Notes Payable:
 Additional
    
    
    
    
    
    
    OriginalShares of
    
    
    
    
    
    
    Warrants
    
    
    
    
    
    
    WarrantsPremium
    
    
    
    
    
    
    Common
    
    
    Additional
    
    
    Issued:
    
    
    Original
    
    
    Revised:Principal
    
    
    Paid on
    
    
    Interest
    
    
    Stock
    
    
    Warrants
    
    
    Exercise
    
    
    Warrants
    
    
    ExerciseRetired
    
    
    Retirement
    
    
    Paid
    
    
    Issued
    
    
    Issued
    
    
    Price
    
    
    Re-priced
    
    
    PriceStock RedemptionsMay 2, 2005
    
    $
    
    
    
    $
    
    
    
    $
    267,000
    
    
    
    97,316
    
    
    
    
    
    
    $
    
    
    
    
    
    
    
    $
    August 2, 2005
    
    
    
    
    
    
    
    
    
    
    320,000
    
    
    
    116,786
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    September 23, 2005
    
    
    2,211,000
    
    
    
    110,000
    
    
    
    21,000
    
    
    
    1,102,954
    
    
    
    
    
    
    
    
    
    
    
    118,672
    
    
    
    2.15October 28, 2005
    
    
    1,629,000
    
    
    
    81,000
    
    
    
    26,000
    
    
    
    948,834
    
    
    
    
    
    
    
    
    
    
    
    87,442
    
    
    
    1.82November 2, 2005
    
    
    
    
    
    
    
    
    
    
    259,000
    
    
    
    149,914
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    December 1, 2005
    
    
    2,258,000
    
    
    
    113,000
    
    
    
    14,000
    
    
    
    1,425,278
    
    
    
    
    
    
    
    
    
    
    
    125,914
    
    
    
    1.69December 9, 2005
    
    
    1,951,000
    
    
    
    98,000
    
    
    
    15,000
    
    
    
    1,433,051
    
    
    
    
    
    
    
    
    
    
    
    217,550
    
    
    
    1.44Total stock
    
    $
    8,049,000
    
    
    $
    402,000
    
    
    $
    922,000
    
    
    
    5,274,133
    
    
    
    
    
    
    
    
    
    
    
    549,578Cash PaymentsFebruary 2, 2005
    
    $
    
    
    
    $
    
    
    
    $
    267,000
    
    
    
    
    
    
    
    
    
    
    $
    
    
    
    
    
    
    
    $
    December 9, 2005
    
    
    1,951,000
    
    
    
    98,000
    
    
    
    15,000
    
    
    
    
    
    
    
    145,032
    
    
    
    5.38
    
    
    
    
    
    
    
    December 30, 2005
    
    
    5,000,000
    
    
    
    250,000
    
    
    
    61,000
    
    
    
    
    
    
    
    650,558
    
    
    
    5.38
    
    
    
    
    
    
    
    Total cash
    
    $
    6,951,000
    
    
    $
    348,000
    
    
    $
    343,000
    
    
    
    
    
    
    
    795,590
    
    
    
    
    
    
    
    Total 2005
activity
    
    $
    15,000,000
    
    
    $
    750,000
    
    
    $
    1,265,000
    
    
    
    5,274,133
    
    
    
    795,590
    
    
    
    
    
    
    
    549,578
   F-25




---



##### Table of Contents



Early payment premium
    
    $
    250,000Write-off of unamortized discount
    
    
    595,000Write-off of unamortized deferred financing costs
    
    
    338,000Value of additional warrants issued
    
    
    100,000Loss on extinguishment of debt
    
    $
    1,283,000
     Promissory Note Payable
  F-26




---



##### Table of Contents



Short-term Note Payable
  12. Equity Financing Arrangements and Related Warrants
 Warrants Summary
  December 31,
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    December 31,2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2005Warrants
    
    
    Exercise
    
    
    Warrants
    
    
    Warrants
    
    
    Repriced
    
    
    Warrants
    
    
    WarrantWarrant Grants:
    
    Outstanding
    
    
    Price
    
    
    Issued
    
    
    Exercised
    
    
    Warrants
    
    
    Outstanding
    
    
    Expiration
    
    
    Share Deficiency2005 Private Placement
    
    
    
    
    
    $
    3.04
    
    
    
    3,466,274
    
    
    
    
    
    
    
    
    
    
    
    3,466,274
    
    
    Aug 2010
    
    
    2005 Private Placement broker
warrants
    
    
    
    
    
    
    3.04
    
    
    
    108,964
    
    
    
    
    
    
    
    
    
    
    
    108,964
    
    
    Aug 2010
    
    
    Agent for 2005 Private Placement
    
    
    
    
    
    
    3.04
    
    
    
    178,111
    
    
    
    
    
    
    
    
    
    
    
    178,111
    
    
    Aug 2010
    
    
    2003 Private Placement
    
    
    181,452
    
    
    
    4.96
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    181,452
    
    
    June 2007
    
    
    2002 Private placement of
convertible equity securities
    
    
    648,172
    
    
    
    1.73
    
    
    
    
    
    
    
    (648,172
    )
    
    
    
    
    
    
    
    
    
    Sept 2005
    
    
    2002 Private placement of
convertible equity securities 
additional warrants issued due to
anti-dilution protection
    
    
    
    
    
    
    1.73
    
    
    
    561,540
    
    
    
    (561,540
    )
    
    
    
    
    
    
    
    
    
    Sept 2005
    
    
    Series A Convertible Preferred Stock
    
    
    243,899
    
    
    
    3.90
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    243,899
    
    
    Sept 2006
    
    
    Series B Convertible Preferred Stock
    
    
    270,509
    
    
    
    3.90
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    270,509
    
    
    Sept 2006
    
    
    2002 private placement of equity
securities
    
    
    916,667
    
    
    
    57.60
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    916,667
    
    
    May 2010
    
    
    Promissory note payable (see Note 11)
    
    
    145,853
    
    
    
    13.01
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    145,853
    
    
    Jan 2007
    
    
    Warrants related to convertible promissory notes payable (see Note 11)Convertible promissory note
payable, initial warrants
    
    
    1,000,000
    
    
    
    5.38
    
    
    
    
    
    
    
    
    
    
    
    (549,578
    )
    
    
    450,422
    
    
    Nov 2009
    
    
    293,331Re-pricing of initial warrants,
Sept 23, 2005
    
    
    
    
    
    
    2.15
    
    
    
    
    
    
    
    
    
    
    
    118,672
    
    
    
    118,672
    
    
    Nov 2009
    
    
    59,336Re-pricing of initial warrants,
Oct 28, 2005
    
    
    
    
    
    
    1.82
    
    
    
    
    
    
    
    
    
    
    
    87,442
    
    
    
    87,442
    
    
    Nov 2009
    
    
    43,721Re-pricing of initial warrants,
Dec 1, 2005
    
    
    
    
    
    
    1.69
    
    
    
    
    
    
    
    
    
    
    
    125,914
    
    
    
    125,914
    
    
    Nov 2009
    
    
    62,957Re-pricing of initial warrants,
Dec 9, 2005
    
    
    
    
    
    
    1.44
    
    
    
    
    
    
    
    
    
    
    
    217,550
    
    
    
    217,550
    
    
    Nov 2009
    
    
    98,277Increase due
to repricing for 2005Private Placement
    
    
    
    
    
    
    5.38
    
    
    
    115,244
    
    
    
    
    
    
    
    
    
    
    
    115,244
    
    
    Nov 2009
    
    
    Additional warrants issued with
cash payment of convertible
promissory notes payable
    
    
    
    
    
    
    5.38
    
    
    
    795,590
    
    
    
    
    
    
    
    
    
    
    
    795,590
    
    
    Nov 2006  Nov 2008
    
    
    196,783Convertible promissory note broker warrants
    
    
    166,667
    
    
    
    6.00
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    166,667
    
    
    Nov 2009
    
    
    Total
    
    
    3,573,219
    
    
    
    
    
    
    
    5,225,723
    
    
    
    (1,209,712
    )
    
    
    
    
    
    
    7,589,230
    
    
    
    
    
    
    
    754,405
  F-27




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##### Table of Contents



2005 Private Placement of Common Stock and Warrants
      2004 Private Placement of Convertible Notes Payable and Related Transactions in 2005
    F-28




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##### Table of Contents



2003 Private Placement of Common Stock and Warrants
  2002 Private Placement of Convertible Equity Securities and Warrants
  
    
    Warrants related to the issuance of $8,000,000 of convertible notes Concurrent with the
issuance of $8,000,000 of convertible notes in September 2002, the Company issued immediately
exercisable warrants to purchase 386,473 shares of the Companys common stock at a price per
share of $4.14. In April 2003, the Company and the former noteholders completed a warrant
exercise and replacement program whereby the Company received $1,600,000 in cash as a result
of the noteholders exercising their original warrants and issued replacement warrants to the
noteholders to purchase 455,017 shares of the Companys common stock at $5.00 per share.
Subsequently, as a result of the Companys private placement in June 2003, the Elron Software
acquisition in September 2003, redemptions of the convertible notes throughout 2005 and the
Companys private placement of common stock in August 2005, and certain anti-dilution
provisions of the replacement warrants, the price per common share pursuant to these
replacement warrants was reduced from $5.00 to $1.44 and the number of common shares
available for purchase was increased from 648,172 to 1,209,712. The additional warrants were
assigned a value of $249,000 using the BSOPM, which was reallocated from the original
additional paid-in capital that was recorded at the time the initial warrants were issued.
All 1,209,712 warrants were exercised for total proceeds of $2,088,365, or an average of
$1.73 per share. At December 31, 2005 none of these warrants remain outstanding.
    
    Warrants related to the issuance of $3,250,000 of Series A Convertible Preferred Stock
Concurrent with the issuance of $3,250,000 of Series A Convertible Preferred Stock in
September 2002, the Company issued warrants to purchase 288,244 shares of the Companys
common stock at a price per share of $4.42. The fully-exercisable warrants expire in
September 2006 and the exercise price is subject to certain anti-dilution adjustments. As a
result of the Companys private placement in June 2003, the Elron Software acquisition in
September 2003, redemptions of the convertible notes throughout 2005 and the Companys
private placement of common stock in August 2005, the exercise price per common share was
adjusted from $4.42 to $3.90. At December 31, 2005, 243,899 of these warrants were
outstanding.
    
    Warrants related to the issuance of $4,750,000 of Series B Convertible Preferred Stock
Concurrent with the issuance of $4,750,000 of Series B Convertible Preferred Stock in
September 2002, the Company issued warrants to purchase 421,284 shares of the Companys
common stock at a price per share of $4.42. The fully-exercisable warrants expire in
September 2006 and the exercise price is subject to certain anti-dilution adjustments. As a
result of the Companys private placement in June
2003, the Elron Software acquisition in September 2003, redemptions of the convertible notes
throughout 2005 and the
 F-29




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##### Table of Contents



2002 Private Placement of Equity Securities
  13. Employee, Director and Other Stock Options and Grants
  Authorized
    
    
    Options
    
    
    AvailableShares
    
    
    Outstanding
    
    
    for GrantEmployee and Director Stock Option Plans:1990 Stock Option Plan
    
    
    345,045
    
    
    
    31,250
    
    
    
    1992 Stock Option Plan
    
    
    450,000
    
    
    
    73,166
    
    
    
    1995 Long-term Incentive Plan
    
    
    1,825,000
    
    
    
    1,492,700
    
    
    
    1996 Directors Stock Option Plan
    
    
    225,000
    
    
    
    62,500
    
    
    
    1999 Directors Stock Option Plan
    
    
    975,000
    
    
    
    853,917
    
    
    
    2001 Stock Option Plan
    
    
    2,525,000
    
    
    
    1,129,509
    
    
    
    929,5812001 Employee Stock Option Plan
    
    
    300,000
    
    
    
    241,977
    
    
    
    14,4762003 New Employee Stock Option Plan
    
    
    500,000
    
    
    
    491,100
    
    
    
    8,9002004 Stock Option Plan
    
    
    3,200,000
    
    
    
    1,037,631
    
    
    
    2,162,3692004 Directors Stock Option Plan
    
    
    300,000
    
    
    
    285,000
    
    
    
    15,000Cook Employee Transferred Options
    
    
    807,127
    
    
    
    18,000
    
    
    
    Total employee and director stock option
plans
    
    
    11,452,172
    
    
    
    5,716,750
    
    
    
    3,130,326Executive Stock Option Agreements:John A. Ryan, former Chairman and CEO
    
    
    1,000,000
    
    
    
    1,000,000
    
    
    
    Richard D. Spurr, Chairman, President and CEO
    
    
    650,000
    
    
    
    650,000
    
    
    
    Other executive stock option agreements
    
    
    450,000
    
    
    
    158,665
    
    
    
    Total executive stock option agreements
    
    
    2,100,000
    
    
    
    1,808,665
    
    
    
    Other Stock Option Agreements
    
    
    70,000
    
    
    
    70,000
    
    
    
    Total
    
    
    13,622,172
    
    
    
    7,595,415
    
    
    
    3,130,326
 Employee and Director Stock Option Plans
  Cook Employee Transferred Options
 F-30




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##### Table of Contents



Executive Stock Option Agreements:
 John A. Ryan
 Richard D. Spurr
 Other Executive Stock Option Agreements
 Other Stock Option Agreements:
  Stock Option Activity
  Weighted AverageShares
    
    
    Exercise PriceOutstanding at January 1, 2003
    
    
    6,515,017
    
    
    $
    8.77Granted at market price
    
    
    2,436,676
    
    
    $
    4.54Cancelled
    
    
    (1,105,589
    )
    
    $
    10.42Exercised
    
    
    (1,885,387
    )
    
    $
    5.83Outstanding at December 31, 2003
    
    
    5,960,717
    
    
    $
    7.66Granted at market price
    
    
    3,793,716
    
    
    $
    6.99Cancelled
    
    
    (728,592
    )
    
    $
    9.15Exercised
    
    
    (1,005,812
    )
    
    $
    5.47Outstanding at December 31, 2004
    
    
    8,020,029
    
    
    $
    7.64Granted at market price
    
    
    976,200
    
    
    $
    3.64Granted above market price
    
    
    138,780
    
    
    $
    3.05Cancelled and expired
    
    
    (1,528,761
    )
    
    $
    7.72Exercised
    
    
    (10,833
    )
    
    $
    2.61Outstanding at December 31, 2005
    
    
    7,595,415
    
    
    $
    7.03
  Options Outstanding
    
    Options ExercisableWeightedAverage
    
    Weighted
    
    
    
    
    
    WeightedRange of
    
    Number
    
    Remaining
    
    Average
    
    Number
    
    AverageExercise Prices
    
    Outstanding
    
    Contractual Life
    
    Exercise Price
    
    Exercisable
    
    Exercise Price$  1.96 - $  4.99
    
    
    2,534,047
    
    
    
    7.65
    
    
    $
    3.99
    
    
    
    1,238,326
    
    
    $
    4.15$  5.00 - $  5.75
    
    
    1,756,968
    
    
    
    4.17
    
    
    $
    5.17
    
    
    
    1,705,872
    
    
    $
    5.18$  6.00 - $  8.89
    
    
    1,617,163
    
    
    
    6.55
    
    
    $
    6.77
    
    
    
    1,183,830
    
    
    $
    6.98$  9.00 -
$19.75
    
    
    1,465,209
    
    
    
    5.67
    
    
    $
    10.57
    
    
    
    1,077,033
    
    
    $
    10.63$21.38 -
$44.63
    
    
    222,028
    
    
    
    3.66
    
    

$
    35.01
    
    
    
    222,028
    
    
    $
    35.017,595,415
    
    
    
    
    
    

$
    7.03
    
    
    
    5,427,089
    
    
    $
    7.64
 F-31




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##### Table of Contents



Reserved Common Stock
  Employee Stock Purchase Plan
  Stock Compensation
  2005
    
    
    2004
    
    
    2003Stock compensation relating to accelerated option
vesting
    
    $
    
    
    
    $
    1,115,000
    
    
    $
    Stock granted in lieu of compensation
    
    
    1,012,000
    
    
    
    2,779,000
    
    
    
    484,000Stock options granted to third parties
    
    
    110,000
    
    
    
    179,000
    
    
    
    550,000Total
    
    $
    1,122,000
    
    
    $
    4,073,000
    
    
    $
    1,034,000
   14. Earnings Per Share and Potential Dilution
  2005
    
    
    2004
    
    
    2003Net loss from continuing operations before
preferred stock dividends
    
    $
    (43,596,000
    )
    
    $
    (42,040,000
    )
    
    $
    (27,667,000
    )Preferred stock dividends
    
    
    
    
    
    
    
    
    
    
    (1,405,000
    )Net loss from continuing operations
attributable to common stock
    
    $
    (43,596,000
    )
    
    $
    (42,040,000
    )
    
    $
    (29,072,000
    )Loss from continuing operations per common
share basic and diluted
    
    $
    (1.20
    )
    
    $
    (1.33
    )
    
    $
    (1.23
    )Weighted average common shares  basic
and diluted
    
    
    36,452,000
    
    
    
    31,533,000
    
    
    
    23,525,077
 F-32




---



##### Table of Contents



2005
    
    
    2004
    
    
    2003Stock options
    
    
    7,595,415
    
    
    
    8,020,029
    
    
    
    6,048,217Warrants issued in relation to debt and equity
arrangements (see Note 12)
    
    
    7,589,230
    
    
    
    3,573,219
    
    
    
    3,643,778Shares issuable for conversion of convertible
promissory notes payable (see Note 11)
    
    
    929,368
    
    
    
    3,333,333
    
    
    
    Total antidilutive securities excluded from EPS
calculation
    
    
    16,114,013
    
    
    
    14,926,581
    
    
    
    9,691,995
      15. Significant Customers
  F-33




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##### Table of Contents



16. Commitments and Contingencies
 Leases and Debt
   2006
    
    
    2007
    
    
    2008
    
    
    2009
    
    
    2010
    
    
    Thereafter
    
    
    TotalDebt
    
    $
    5,268,000
    
    
    $
    2,700,000
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    7,968,000Operating leases
    
    
    1,397,000
    
    
    
    1,235,000
    
    
    
    1,028,000
    
    
    
    958,000
    
    
    
    887,000
    
    
    
    3,327,000
    
    
    
    8,832,000Capital lease
    
    
    165,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    165,000Total cash obligations
    
    
    6,830,000
    
    
    
    3,935,000
    
    
    
    1,028,000
    
    
    
    958,000
    
    
    
    887,000
    
    
    
    3,327,000
    
    
    
    16,965,000Interest on
obligations
    
    
    358,000
    
    
    
    156,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    514,000Total
    
    $
    7,188,000
    
    
    $
    4,091,000
    
    
    $
    1,028,000
    
    
    $
    958,000
    
    
    $
    887,000
    
    
    $
    3,327,000
    
    
    $
    17,479,000
    Lawsuits
    F-34




---



##### Table of Contents



17. Income Taxes
  2005
    
    
    2004
    
    
    2003Current:U.S.
    
    $
    
    
    
    $
    
    
    
    $
    State
    
    
    30,000
    
    
    
    
    
    
    
    Foreign
    
    
    59,000
    
    
    
    501,000
    
    
    
    167,000Deferred:Foreign
    
    
    
    
    
    
    (16,000
    )
    
    
    (19,000
    )$
    89,000
    
    
    $
    485,000
    
    
    $
    148,000
  2005
    
    
    2004
    
    
    2003Expected tax benefit at U.S. statutory
rate
    
    $
    (14,760,000
    )
    
    $
    (14,128,000
    )
    
    $
    (9,336,000
    )Unbenefited U.S. losses, net
    
    
    14,772,000
    
    
    
    14,144,000
    
    
    
    9,571,000Nondeductible expense
    
    
    47,000
    
    
    
    469,000
    
    
    
    State income taxes
    
    
    30,000
    
    
    
    
    
    
    
    Other
    
    
    
    
    
    
    
    
    
    
    (87,000
    )$
    89,000
    
    
    $
    485,000
    
    
    $
    148,000
  2005
    
    
    2004Deferred tax assets:Reserves currently nondeductible
    
    $
    1,614,000
    
    
    $
    630,000U.S. net operating loss carryforwards
    
    
    83,153,000
    
    
    
    72,527,000State net operating loss carryforwards
    
    
    2,167,000
    
    
    
    1,761,000Capital loss carryforwards
    
    
    987,000
    
    
    
    987,000Tax credit carryforwards
    
    
    3,033,000
    
    
    
    2,986,000Stock-based compensation
    
    
    1,540,000
    
    
    
    3,519,000Start-up costs
    
    
    96,000
    
    
    
    96,000Intangible assets
    
    
    4,731,000
    
    
    
    1,371,000Depreciable assets
    
    
    1,981,000
    
    
    
    1,966,000Other assets
    
    
    238,000
    
    
    
    47,000
 F-35




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##### Table of Contents



2005
    
    
    2004Total deferred tax assets
    
    
    99,540,000
    
    
    
    85,890,000Less valuation allowance
    
    
    (99,325,000
    )
    
    
    (85,528,000
    )Net deferred tax assets
    
    
    215,000
    
    
    
    362,000Deferred tax liability:Prepaid Interest
    
    
    (180,000
    )
    
    
    (327,000
    )Net deferred income taxes
    
    $
    35,000
    
    
    $
    35,000
    18. Related Party Transactions
  19. Employee Benefit Plan
 4 01(k) Plan
 20. Discontinued Operations
    21. International Distribution Agreement
  F-36




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##### Table of Contents



22. Quarterly Results of Operations (Unaudited)
  Quarter EndedMarch 31
    
    
    June 30
    
    
    September 30
    
    
    December 312005Revenues
    
    $
    3,583,000
    
    
    $
    3,449,000
    
    
    $
    3,484,000
    
    
    $
    3,448,000Cost of revenues
    
    
    (3,891,000
    )
    
    
    (3,508,000
    )
    
    
    (3,580,000
    )
    
    
    (3,215,000
    )Net loss
    
    
    (9,572,000
    )
    
    
    (8,915,000
    )
    
    
    (14,481,000
    )
    
    
    (10,628,000
    )Basic and diluted
net loss per common
share
    
    
    (0.30
    )
    
    
    (0.28
    )
    
    
    (0.40
    )
    
    
    (0.24
    )2004Revenues
    
    $
    2,843,000
    
    
    $
    3,521,000
    
    
    $
    3,853,000
    
    
    $
    3,910,000Cost of revenues
    
    
    (3,174,000
    )
    
    
    (3,704,000
    )
    
    
    (4,541,000
    )
    
    
    (4,459,000
    )Net loss
    
    
    (10,938,000
    )
    
    
    (9,876,000
    )
    
    
    (10,704,000
    )
    
    
    (10,522,000
    )Basic and diluted
net loss per common
share
    
    
    (0.36
    )
    
    
    (0.31
    )
    
    
    (0.33
    )
    
    
    (0.33
    )
  
    
    In the first quarter of 2005 the Company sold its MI/WI product lines to Cyberguard,
resulting in a gain of $1,035,000. (see Note 4). The MI/WI product line revenues were
$637,000 in the first quarter of 2005.
    
    The interest expense incurred in the second, third, and fourth quarters of 2005 includes
amortization of a beneficial conversion feature totaling $2,518,000 resulting from the April
2005 restructuring of the $20,000,000 convertible promissory note payable (see Note 11).
    
    In third quarter of 2005 the Company sold its MyDocOnline product (Dr. Chart) to MITEM,
resulting in a loss of $4,751,000 (see Note 4). Dr. Chart contributed revenues of $70,000,
$125,000, and $135,000 in the first, second, and third quarter of 2005, respectively.
  
    
    In the first quarter of 2004, the Company acquired substantially all of the operating
assets and businesses of MyDocOnline (see Note 4). The results of operations from these
acquisitions are included in the Companys results of operations from their dates of
acquisition.The higher losses in first and third quarters of 2004 are mainly related to the following:
    
    The Company incurred an $886,000 non-cash expense in first quarter resulting from the
acceleration of vesting of certain stock options held by employees who were severed from the
Company.
    
    In third quarter 2004 the Company elected to discontinue the Connect product purchased in
the MyDocOnline acquisition. This resulted in a write-down of $675,000 of the net value
attributed to the MyDocOnline purchase.
 F-37